Herbalife's Circular Reference - 'Popping The Question'

| About: Herbalife Ltd. (HLF)

David Einhorn asked Herbalife (NYSE:HLF) President Des Walsh "The Question" on an Herbalife Q1, 2012 conference call. "What is the percentage of sales sold outside the Herbalife network?"

What follows is a list of the different answers Herbalife executives have provided over the past year to "The Question."

Des Walsh, President of Herbalife answered the question as follows:

David Einhorn: "I got a couple of questions for you. First is, how much of the sales that you'd make in terms of final sales are sold outside the network and how much are consumed within the distributor base?"

Des Walsh: "So, David, we have a 70% customer rule which it basically says that 70% of all product is sold to consumers or actually consumed by distributors for their own personal use. So obviously what we've seen with nutrition clubs is that we now have visibility for the first time to our customers. We know that we reported on this call for the first time the number of commercial clubs around the world, which is in excess of 30,000, so that has given us visibility to the tremendous amount of products that are being sold directly to the consumers and we see that as a growing trend in our business."

David Einhorn: "So, what is the percentage that actually sold to consumers that are not distributors?"

Des Walsh: "So, we don't have an exact percentage David because we don't have visibility to that level of detail."

David Einhorn: "Do you have an approximation?"

Des Walsh: "So well again going back to our 70%, where we believe is that it is that 70% or potentially in excess of that."


In January after Bill Ackman revealed his Short thesis on Herbalife, CEO Michael Johnson went on CNBC to defend the company and said the following:

On December 19th, CNBC Correspondent Kate Kelly interviewed Mr. Johnson on Street Signs. Here is the transcript:

Here is the video:

Kate Kelly : "Mr. Johnson, one of the concerns aired by folks that consider your company to be a pyramid scheme. And this is something that has come to you through the country of Belgium in a lawsuit. More recently today through Bill Ackman. Questions have been raised by other major investors including David Einhorn. Are the sales that go on of your products confined to your own distribution network. Is that the case or is it broader than that?"

Johnson: "We have millions of customers. Millions upon millions of customers. Lieberman Research was hired by us to go out and verify and validate that. We've been validating it for the past two quarters. We will continue to do that. That's never been a problem. None with the FTC. None with anyone. Our customers are sometimes called distributors. That's the only confusion that we have. And they are distributors because they get a discount on our products."

Kate Kelly: "Can you give us a percentage figure though Mr. Johnson as to what percentage of your sales are outside that distribution network."

Johnson: "90%"

Kelly: "So the vast majority."

Johnson: "ABSOLUTELY!"


On January 10th, Kate Kelly sat down again with Mr. Johnson after an Investor Presentation made by the company that asserted that in the US, Herbalife has 5.7 million individual households who consume Herbalife products.

Here is a transcript of that exchange.

Here is the video:

Kate Kelly: "Let's talk a little bit more about that customer base. You said the last time I spoke to you, which was live a couple of weeks ago, that 90% of your product is sold outside of the network meaning not in a Nutrition Club for example. Tell us more about that statistic. Because you also said historically you don't track the numbers. You don't know exactly where the sales are. So where does that 90% come from?"

Johnson: "It was a misstatement. 90% of our distributors, OK, are buying our product, and let me just try to clarify this, buy it for one reason and they buy it for the self-consumption."

Later on in the same Interview, Mr. Johnson states:

Kelly: "To the best of your knowledge though Michael, what percentage of your products are sold outside the network, what percentage are sold within the network?"

Johnson: "I don't have a number for you."

Kelly: "You don't have a ballpark estimate."

Johnson: "You know I got in trouble doing that last time. So, let's go back, check the facts. Get Lieberman to look at all of the numbers with us. We know who we sell to. We do not know who they sell to. And there's nothing wrong with the way we do our business. There is absolutely nothing wrong with it."


In Herbalife's 10k, the company says the following:

"We segment the distributors who have not attained the sales leader level into three general categories based on their product order patterns: discount buyers, small retailers and potential sales leaders.

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.

We rely on certifications from the selling distributors as to the amount and source of product sales to other distributors which are not directly verifiable by us."


Am I the only investor who is a tad confused?

On the one hand, Herbalife does not have the data to tell us what % of their sales are made outside of the distribution network. On the other hand, they are able to tell us that 90% of distributors do not resell the product.

On the one hand, they are able to segment their distributors into 3 distinct segments. On the other, we are told that the company does not have access to the kind of data that would actually allow them to perform that kind of segmentation.

Or do they?

Think of a simple algebraic formula A + B = C

If we know two of the variables, we can obviously solve for the other.

Let C be Total Sales

Let A be sales to Distributors for Self Consumption

Let B be sales to Distributors for Resale

Mr. Johnson told CNBC that 90% of distributors buy Herbalife product for "one reason... for self consumption."

So, if the company knows which 90% buy to consume themselves, then they know which 10% buy to resell.

It would seem easy to then determine which % of sales go to the 90% and which % of sales volume goes to the 10% who resell.

Seems simple, Yes?

Except Mr. Walsh, the President of Herbalife tells us a different story. Mr. Walsh tells Mr. Einhorn that he estimates that over 70% of net sales are made outside of the network. This certainly seem like quite a feat. If you consider that 90% are simply self-consuming, this implies that the remaining 10% of distributors are responsible for 100% of the 70% "outside sales" the company makes.

Mr. Walsh wants us to believe there are millions of outside customers being serviced by less than 10% of the company's distributors.

Let's think about the logic here for a moment. Let's think about that claim.

If I want to buy Herbalife to consume it I can:

a) sign-up as a self-consumer, like 90% of HLF's distributors according to Mr. Johnson, as a Club buyer to consume the product myself for 25% off plus shipping.


b) I can stay outside of the network and buy the product for 100% of Suggested Retail Price as a retail customer?

Which choice would you make (assuming you don't buy on eBAY)?

Now, think about the following question. If Herbalife company policies allow customers to sign up as distributors to buy the product, how on earth is a low-level distributor supposed to compete with that policy to actually sell final product at retail? Who on earth would want to go in to that kind of business?

Why would anyone pay me $1 plus shipping for a can of Formula 1 when the company places no restrictions on the same person's ability to just buy it directly from the company for $75 cents?

How do the company's policies protect wholesale margins for Non-Sales Leaders who may want to build a business?

How do they even begin to promote "outside sales"?

In prior articles, I have posted on Seeking Alpha, individuals around the world keep telling me in the "Comments" section that Herbalife's low-level distributors are not in fact distributors at all, but rather are discount customers.

These comments from places like Croatia seem to be consistent with Mr. Johnson's latest statements that "90% of distributors buy for self-consumption."

But, if these statements are true, doesn't this beg the obvious question:

"If 90% of distributors who want to buy shakes from Herbalife do so at a 25% discount, then who on earth is paying actual suggested retail price for the product?"

More importantly, if 90% of Herbalife distributors aren't doing any distributing, then how is the company supposed to keep growing?

If 90% of Herbalife distributors buy "for one reason... self consumption" and..."typically... these distributors stay for several months to one year.", what is going to happen to Herbalife's distributor base a year from now? If we accept what the company is telling us, won't 90% of these distributors be long gone?

As an investor, I am thoroughly confused by Herbalife's policies, procedures, disclosures and public statements and they make no sense to me:

1. If Herbalife wanted distributors to make actual retail sales at suggested retail price as legitimate wholesalers, why do they knowingly let individuals who have no intention of ever reselling the product buy it for a discount?

2. If Herbalife needs to demonstrate to regulators that 50% of sales are "outside sales" that generate legitimate retail traffic, why don't they track this data and why do they allow individuals who have no plans to resell to become part of their distributor network?

3. If Herbalife distributors are out there recruiting customers instead of legitimate distributors to fill out their downlines, what will fuel the company's sales growth in the future?

4. If very few of Herbalife's non-Sales Leaders are distributors, why do they call them distributors? Why don't they call them something else? Why is the company telling investors it has more real distributors than it really has in its financial disclosures? According to Mr. Johnson's CNBC interview on January 10th, 90% of distributors aren't distributors at all.

Am I the only one who finds the company's disclosures thoroughly inconsistent and misleading?

What is an investor to believe? Why is the company so opaque?

If the company really doesn't have the data to tell us who buys what from whom and for what reason, why does it tell us with certainty that some things are true while it cannot give us any certainty on other variables in the same formula?

If Herbalife were a legitimate MLM it would have:

a) Lots of legitimate distributors who actually resell the product to:

b) Lots of legitimate customers who sit "outside" the distribution network for:

c) Final prices that allow the distributor to capture a meaningful profit/mark-up, and

d) Management reporting and public disclosures to prove these facts.

Instead, Mr. Johnson tells us that:

a) Only 10% of distributors are actually distributors

b) 90% of distributors are actually not distributors but customers,

c) None of these "inside" customers are paying Suggested Retail Price for the volume they consume

d) Most of these "inside" customers leave within a year, and

e) He has no idea who buys what at retail.

Which leads me to my final questions, if:

a) 90% of distributors aren't selling and

b) "inside customers" get better prices than "outside customers" and

c) "inside customers" churn off the product in less than a year and

d) Only 10% of distributors actually resell to the outside world then,




Herbalife's public disclosures on "The Question" are like a circular reference in Microsoft Excel. The statements issued by the company's executives simply do not fit together logically, nor do the official disclosures made in the company's 10k.

Perhaps this is the subject of the SEC's ongoing inquiry into the company?

Certainly, if executives seem confused, what are investors supposed to conclude?

I am now coming to the conclusion that the way Herbalife actually works is as follows:

  • Most non-Sales leaders distributors are in fact the company's final customers.
  • Herbalife misleads us as investors by calling them distributors.
  • Most non-Sales leaders do not recruit.
  • Most non-Sales Leaders will leave in less than a year.
  • Most non-Sales Leaders pay 75 cents on the $ for their products and,
  • Herbalife must not have a material customer base outside of the bottom level of its pyramid that is paying full retail price for the product.

On the recruitment side:

  • A small percentage of registered Herbalife distributors actually recruit.
  • Most of the time they are actually recruiting for customers and not distributors.
  • Customers get signed-up as distributors to protect the recruiter's down-line Volume Points.
  • Very few recruits last more than a year.
  • Very few recruiters successfully build out a legitimate salesforce and
  • Very few new recruiters make any lifestyle money.

This suggests that the majority of Herbalife sales are in fact "inside sales" and that the amount of "outside sales" at full retail price are the exception and not the rule.

This conclusion would also seem to support Mr. Ackman's view that Herbalife is a pyramid scheme.

Pop the Question Yourself. I would love to know what you think.

Disclosure: I am short HLF. 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.

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