Herbalife Is A Fraud Because It Is A Distributor

Jan.25.13 | About: Herbalife Ltd. (HLF)

Investors who ignore Herbalife's regulatory risks do so at their own peril. This article explores, specifically how Herbalife misleads its new recruits by overstating their potential for success when they pursue Herbalife's business opportunity. It also builds upon my arguments in prior articles for why Herbalife is a Short.

Pershing Square presented an argument that Herbalife (NYSE:HLF) is a fraud because it is a pyramid scheme. Following their presentation I delved into the company's 10ks, historical transcripts, legal cases, etc. I endeavored to do my own independent analysis to assess Herbalife's business. I am not sure that Herbalife is a pyramid scheme, odds are it is, but I am convinced that the company is a fraud.

This article articulates the reasons why.

Q. Does Herbalife sell product directly to final customers?

The evidence I have collected on this question overwhelmingly supports the position that many of Herbalife's distributors are not distributors at all but rather are final customers. Consider the following:

1) In the company's 10k Herbalife states:

"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.

2) In an interview on CNBC on January 10, CEO Michael Johnson made the following statement.

"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."

Herbalife tells us that they are in the Direct Sales business. Herbalife tells us that many of its distributors don't even try to resell the product.

Ergo: Herbalife tells us that in practice, Herbalife is, itself, a distributor.

Consider the case of a rational customer. Let's call this customer Bob. Bob wants to lose weight and is introduced to Herbalife Formula 1.

Who can Bob buy the product from and what would he pay?

Bob can buy the product directly from Herbalife and receive a 25% discount by signing-up as a distributor.

Bob can buy the product from a Sales Leader. A Sales Leader buys product for 50% off and can resell to Bob for 25% off. In practice, many Sales Leaders sign discount customers up as distributors to secure Volume Points under their Herbalife IDs.

Bob can buy the product online, perhaps through eBAY for 25% off. In this case, Bob is really just buying from another distributor who is using the web as a channel.

In the first 3 examples, Bob would be indifferent as to who he buys the product from as he can secure a 25% discount from any of these channels.

What if Bob buys from a Non Sales Leader?

Bob can certainly buy from a Non-Sales Leader.

Can a Non-Sales Leader give Bob a 25% discount on Formula 1 and make money? Can a Non-Sales Leader compete with Sales Leaders and/or Herbalife itself when they act as a distributor.

Herbalife controls the wholesale price that Non Sales Leaders pay for Formula 1. The discount a new, Non Sales Leader receives is 25%. So, if a Non Sales Leader buys $100 of product at the Suggested Retail Price (SRP), Herbalife charges $75.

Concurrently, Herbalife and its Sales Leaders sell product directly to retail customers for the exact same price.

Q. How is a Non Sales Leader supposed to compete with Herbalife for retail customers when:

a) Herbalife controls the price

b) Herbalife sells directly to retail consumers

c) Herbalife gives Sales Leaders a pricing advantage by discriminating against Non Sales Leaders on wholesale prices.

d) Herbalife has no policies nor procedures that prevent retail customers who have no intention of reselling the product from becoming distributors.

Herbalife is in the business of selling two things:

a) It sells products that are marketed as nutritional supplements.

b) It sells a business opportunity.

Herbalife's recruiters travel around the world telling individuals that they can make a living as resellers of Herbalife product. Herbalife tells potential Non-Sales Leaders that they can make money buying Herbalife products for 25% off and can then mark this product up to 100% of SRP and resell it for a profit. Herbalife tells these business prospects that this is the way to make money.

Then, Herbalife makes it virtually impossible for this promise to come true because:

Herbalife is a distributor itself!

Herbalife competes with its own junior distributors for final customers. The salesforce it uses to compete for these customers are its Sales Leaders. Herbalife is in cahoots with its Sales Leaders to undermine the business prospects of its Non Sales Leaders by driving this profit potential out of the marketplace.

Consider the following evidence.

Q. If a distributor who is a retail customer buys product directly from Herbalife for 25% off, who gets the recruiting rewards?

A. The Sales Leader. The Sales Leader gets a kick-back of royalty overrides plus the 25% mark-up whether or not the product is ever resold.

Q. Is Sales Leader compensation tied to the actual retail price a Non Sales Leader receives if they resell the product?

A. No. From Herbalife's perspective and the Sales Leader's perspective, they could not care less if the Non Sales Leader resells the product for a profit at all. Sales commissions and Royalty overrides are paid at the time of purchase, not at the time of sale and are completely based upon SRP and not the actual price of the final sale. There is absolutely no linkage between actual retail sales and the compensation paid to Sales Leaders. This, of course, is the reason so many discount customers get signed-up as distributors. The company makes no efforts at all to protect the SRP in the end-market.

The company and its Sales Leaders pursue volume without regard for the impact their sales policies have on the economic prospects of their junior distributors.

Finally, when a Non-Sales Leader buys product from Herbalife directly, Herbalife pretends that the purchase was actually made by the Sales Leader and compensates that individual accordingly.

Q. If a Sales Leader sells product to a retail customer for 25% off, can they still make money?

A. Sales Leader can buy $100 worth of merchandise for $50, pay $11 Shipping and Handling, pass this cost through and sell to a final customer for $86. The profit on this transaction is $25 for gross margin of 41%.

Effectively, Sales Leaders can undercut Non Sales Leaders in the retail marketplace and price them out of the market.

A Non Sales Leader can buy $100 worth of merchandise for $75, pay $11 Shipping and Handling, pass this cost through and sell to a final customer for $86. The profit on this transaction is $0. Layering in business development costs, the Non Sales Leader must lose money at this price point.

Q. Who controls wholesale pricing?

A. Herbalife. Herbalife creates, organizes and protects the compensation system that makes it and its Sales Leaders unfair competitors v. its Non Sales Leaders

To summarize, why is Herbalife a fraud?

Herbalife is a fraud because it markets a business opportunity to Non Sales Leaders who may legitimately intend to resell Herbalife products to outside customers for a retail profit.

Herbalife then turns around and makes this result virtually impossible.

Herbalife does this in the following ways:

1) It provides preferential wholesale pricing to Sales Leaders. This COGS advantage is a full 41% gross margin points of competitive advantage v. a Non Sales Leader.

2) It sells product directly to retail customers who have no intention of reselling the product. These actual retail customers who become distributors in the downline of Sales Leaders are permanently removed from the opportunity set for Non Sales Leaders. Trying to find legitimate retail customers seems problematic when you are being undercut by none other than Herbalife itself.

3) It sells product directly to retail customers at the same price that it costs a Non Sales Leader to buy the Product.

4) It poisons the end-market for retail consumption by dragging down the market clearing price for retail product to 75% of SRP. This is the market clearing price for distributors who sign-up with Herbalife to consume. This price point guarantees economic loss for Non Sales Leaders and/or guarantees their inability to successfully recruit actual retail customers.

5) It has no policies to prevent channel conflict between the company itself and its Non Sales Leaders. On the contrary, Herbalife competes directly with these Non Sales Leaders for end customers without regard for the final retail price in the retail marketplace.

6) Herbalife's compensation scheme conspires with Sales Leaders to guarantee the economic failure of its Non Sales Leaders.

7) Ultimately, Herbalife controls all wholesale prices, surcharges, processing fees, etc.

More succinctly, Herbalife's representations regarding its business opportunity are fraudulent because:

Herbalife is a Distributor Itself.

By acting as a distributor, competing against its own junior distributors and by discriminating on price with its Sales Leaders against its Non Sales Leaders, Herbalife creates a monopolistic advantage enjoyed by those in the upline at the direct expense of those who are Non Sales Leaders.

These policies undermine fair competition for retail customers, misrepresent the true nature of the business opportunity available to junior distributors, and conspire to guarantee failure due to their fraudulent nature.

Herbalife is a Fraud Because it is a Distributor Itself.

Ironically, Herbalife's efforts to prove it has actual "retail sales" reveals the true conflict of interest in its business model.

Q. How can you claim to be encouraging your distributors to be successful business people when you compete directly with them for final customers, control all wholesale prices in the marketplace, discriminate against Non Sales Leaders on price yet tell them they will inevitably be a smash success?

A. Only if your recruiting practices are fraudulent.

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.