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Bill Ackman's Pershing Square team has used flawed premises and minimal real data analysis in trying to prove pyramid allegations against Herbalife (HLF). Ackman's organization has tried to apply knowledge from its business and personal world to the MLM business model without truly understanding the inner workings of a successful MLM sales organization. It's a whole different world that most people outside of an MLM organization don't understand.

In order to really understand why Ackman's accusation of Herbalife being an illegal pyramid is wrong, you need to have a better understanding of what is involved in developing an MLM sales organization. Almost thirty years ago when I was a young man, my first wife, who is deceased, and I joined an MLM called Amway. I learned a lot from that experience.

When you join a legitimate MLM organization, you can choose the level of success you want to pursue. A lot of distributors join an MLM to just get discounts on the products or to develop a part time business where they can sell products to their friends, family and other contacts making some extra money. Obviously the people pursing this method of MLM participation have a much greater chance of succeeding. Since the cost to participate is usually under a hundred dollars to join an MLM and since the cost of developing a small retail business is minimal, a person who is capable of retailing MLM products can quickly start making some extra money from a very flexible part time business.

Other people start an MLM business to try to develop a sales organization and to make a lot of money like I did. The cost to join the MLM is still under a hundred dollars but the cost involved in developing an MLM organization is substantially more. The amount of time and effort required to develop a large organization is very taxing. As a young man, I found it extremely challenging to build an organization.

When a new distributor would join my team, (whether it was someone I directly recruited, or someone that was recruited by someone else down line within my organization), there was always a tremendous amount of effort by my up line (those distributors above me who had helped recruit and train me for the business), as well as anyone else within my organization benefiting from the sales volume of the new recruit, and myself to try to help the new recruit become successful. It takes a tremendous effort from everyone, especially up line distributor leadership, to build a strong MLM sales organization.

Since it costs very little to join an MLM, some people join an MLM thinking they can easily build a large successful organization without much effort but give up after they encounter a lot of negativity or become frustrated from the difficulties of trying to build an MLM sales organization. It can be very frustrating since it takes a lot of effort just to find someone willing to sign up as a distributor, and then it isn't unusual for a new distributor to quit before they even get started just because a family member, friend, neighbor or contact talks negative about their participation. Also it's even more discouraging, after you have spent a lot of time training and helping another distributor in your organization to build their business, for them to just give up for any number of reasons.

My wife and I had an opportunity to open an apparel store and decided to give up building our MLM business. We were fortunate to have the capital, which dramatically exceeded the cost of starting and building our MLM business, to be able to start that business. Since there are many costs involved in trying to build a successful MLM sales organization, I will admit I never was able to achieve a taxable profit from my MLM business although being in a business with my wife created some very enjoyable tax write offs. Also I will say the lessons learned from my MLM experience have benefited me throughout my entrepreneurial career far exceeding the time and cost involved in pursuing that opportunity.

Now let's look at how this relates to the present situation with Herbalife. Ackman's thesis for Herbalife being a pyramid basically boils down to this-

(Recruiting Rewards) GREATER THAN (Distributor Retail Profit) = ILLEGAL PYRAMID

In his pyramid thesis Ackman takes all expenses classified by Herbalife as "Royalty Overrides" and reclassifies them as "Recruiting Rewards." This is the major theme of his determination that Herbalife is a pyramid and is actually the major flaw in his analysis. By renaming them "Recruiting Rewards,"Ackman makes it sound like these payments are money just passed up line to higher up distributors in Herbalife's MLM for having recruited new MLM participants in to the pyramid scheme. Ackman's theory is that these "Royalty Overrides" are a means for Herbalife to give unearned money to those MLM participants higher up in the pyramid chain to reward them for just recruiting more MLM participants.

In reality these "Royalty Overrides" are a means for Herbalife to reward MLM participants for all of their efforts, as discussed above, in building a sales organization that is selling products to customers as well as consuming those same products. I can guarantee that no one would be willing to put the extreme effort required to build an MLM sales organization if there wasn't a significant reward system such as Herbalife's "Royalty Overrides" compensation structure.

In an MLM, constant contact, counseling, motivational talks, as well as the hosting of training and marketing events is required of the up line distributor leadership just to insure other distributors keep growing their businesses and don't give up. If the distributor leadership of an organization ever lets up on their support of their down line distributors, they risk their entire organization falling apart.

There are actually a lot of similarities between an MLM sales organization and a traditional sales organization. In a typical traditional sales marketing organization, which is also usually a pyramid type organization made up of employees, the Vice President of Sales, various Assistant Vice Presidents of Sales, and various District Sales Managers are paid more money including bonuses, based upon the volume of business created from those sales people within their assigned area of control. They are paid more since they are responsible for hiring, motivating and counseling the people under their control. It is basically the same concept within an MLM organization except that each participant is an independent distributor business and the money paid to the hierarchy is from "Royalty Overrides" or some comparable commission structure.

For financial reporting purposes, instead of listing an expense for "Royalty Overrides," traditional sales organizations list the expense as "Sales Payroll Expense" at the same position in their financial statement. When comparing the two types of organizations, MLM independent distributors actually have a lot more responsibilities since they have to find, recruit, train, monitor and motivate new recruits while continuing to meet their own sales numbers. Traditional sales organizations have a lot of support people to help their sales department such as a human resources department. In fact, usually the top sales management people of a traditional sales organization aren't required to make personal sales, and they make all of their money including bonuses off the sales of other people within their sales organization's pyramid structure.

The reason Herbalife didn't debate Ackman's original presentation point for point about calculating "Recruiting Rewards" is because there are "no recruiting fees" earned by anyone within Herbalife's distributorship network as documented by Herbalife's 1/10/2013 Herbalife Investor Day Presentation slide #85 -

"Herbalife Does Not pay to recruit

- $0 fee, bonus or award is paid on the sale of an International Business Pack

- 0 Volume Points are awarded to any Distributor

- No minimum purchases ever required by any Distributor"

In plain simple terms, Herbalife "Recruiting Rewards" = ZERO. Most people listening to Herbalife's presentation probably overlooked the importance of this fact which was also included on slide #85-

"Misrepresentation: Pershing Square characterizes ALL payments from Herbalife to any Distributor as "Recruiting Rewards."

Since "Recruiting Rewards" are actually zero, it makes it a lot easier to prove Herbalife is not an illegal pyramid scheme. Also, obviously the higher the net profit from retail sales to customers outside the distributor network, the stronger the case against those accusations too. However Herbalife makes two strong points, which I can only encourage Herbalife investors to try to grasp the significance of these statements, which were issued by the FTC regarding pyramid scheme analysis by the FTC and presented on slides #57 and #58 from the above presentation for the 1/10/2013 Herbalife Investor Day Presentation:

"Much has been made of the personal, or internal, consumption issue in recent years. In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme."

"The CRITICAL QUESTION for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from the purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture."

In my opinion these two statements issued by the FTC give MLM's a lot of leeway. It would appear that if an MLM could prove that their goods or services have value and that their goods or services are being sold to non-distributors of the MLM at a profit, then any supporting commissions, like Herbalife's "Royalty Overrides", that are paid by the MLM to distributors would be considered as being paid from revenues.

If we can determine that after excluding the products consumed within Herbalife's distributorship network, Herbalife distributors are able to sell those other products to non-distributors at a reasonable retail price greater than the amount Herbalife charged them for those products, then we can actually conclude that the "Royalty Overrides" are derived from retail sales. Here is the logic behind this conclusion. If Herbalife distributors are selling the non-consumed products to non-distributor customers for less than they purchased them for then they are in essence losing money on the products so they can participate in the "Royalty Overrides" which would be a sign of an illegal pyramid scheme. However if distributors are making money from those product sales too, the "Royalty Overrides" would be considered a means for rewarding distributors who developed the sales organizations retailing those products.

Even if we look at the worse case scenario presented by Ackman's team at Pershing Square on slide #84 of Herbalife's presentation, we can see that it actually shows Herbalife distributors made a $144 million retail profit in 2011 which would mean the "Royalty Overrides" paid by Herbalife in essence are derived from retail sales. Even though Ackman's team cannot show any proof as to the accuracy of their claims that 30% of Herbalife's products are consumed by their distributors, I find it plausible to believe that percentage. However I find it difficult to believe Ackman's giant leap, using analysis of sales of Herbalife products on eBay, in determining that the other 70% of Herbalife products were sold to non-distributor consumers at 65% of suggested retail price so they could derive the above $144 million retail profit figure.

From Herbalife's presentation Slide #27, we can see that Herbalife estimates that 0.1% of Herbalife's products were sold on eBay during the time period 2007 -2012. From my own experience selling and shopping on eBay, I believe most people understand that eBay is a place where most people shop to find bargains. To base a pyramid scheme allegation on a small fraction of Herbalife's product sales via eBay is a stretch for anyone's imagination. It's obvious that Ackman's team doesn't have any solid data on the actual internal consumption, retail sales, and net retail profit by Herbalife distributors. So Ackman's team apparently just assumed various percentages without any legitimate support.

Since I have a background as a CPA, I actually understand Ackman's team's inability to obtain visibility into Herbalife's distributor productivity. The top executives of Herbalife have openly admitted they don't have access to that information either since each distributor is an independent business. If it were even possible, since we don't know how good sales records each independent distributor keeps, it would take a massive effort by anyone to actually derive the correct internal consumption, retail sales and net profit of all Herbalife distributors.

My best guess is that the average retail sales price is probably somewhere between 80% to 90% of suggested retail price and that overall Herbalife distributor total net retail sales profit for the year 2011 was probably somewhere between $1 billion and $2 billion. However I have an even stronger opinion, and that is if the FTC and/or SEC do get involved in any type of investigation of Herbalife at this time, both of them will accept the research performed by Lieberman Research Worldwide (slide #36 through #45 of Herbalife's presentation) as proof of Herbalife having millions of retail customers that are not distributors as well as a reasonably healthy relationship with most former Herbalife distributors. Also, if there is an investigation of Herbalife, I believe the most likely outcome, in the worst possible case scenario, will be to impose additional record keeping requirements on Herbalife and its distributors to better document internal consumption, retail sales, and net retail profit.

So here is my thesis in response to Ackman's team's thesis-

(ZERO Recruiting Rewards) IS LESS THAN ($1.1 Billion+ "Royalty Overrides") plus (somewhere between $144 million & $2 Billion of Distributor Retail Profit) = NOT AN ILLEGAL PYRAMID

NOTE: These numbers are based on calendar year 2011 Herbalife financial information so obviously there will be a significant increase in both "Royalty Overrides" and "Distributor Retail Profit" for the calendar year 2012.

I also believe it's a major contradiction that Ackman's team spent so much time in their presentation explaining to everyone that Herbalife is paying to much for "Royalty Overrides" to their distributors, and then in another part of their presentation trying to tell everyone that distributors aren't making enough money from the business. Which is it? They can't have it both ways.

For anyone thinking that Herbalife is taking advantage of their sales force, I must point out that the highest percentage share (over 38% of Product Sales) of money spent by Herbalife is in rewarding distributors for their efforts with "Royalty Overrides." Also, to further illustrate how much money Herbalife is paying to their distributors, "Royalty Override" payments have approximately been triple the size of Herbalife's "NET INCOME" over the last 3 years. The below chart is derived from Herbalife's 2011 Annual Report page 96:

Description201120102009
*-Product Sales$2,944,722$2,337,493$1,993,617
Royalty Overrides$1,137,560$900,248$761,501
**-Selling, Gen & Admin$1,074,623$887,655$773,911
NET INCOME$412,578$299,215$203,346

(above $ amounts are in thousands)

*- For financial statement purposes, Herbalife includes the sale of marketing materials, which are not for resale by distributors, within "Product Sales" as well as sales from China which aren't subject to "Royalty Overrides." The actual percentage of "Royalty Overrides" derived and paid out to distributors, from actual resalable Herbalife products sold outside of China, is probably closer to 44% since Herbalife makes payments as high as 23% of Suggested Retail Price to their network of distributors.

**-Sales people in China are employed by Herbalife so amounts paid to those Herbalife employees are included in Selling, Gen & Admin as "Sales Payroll Expense."

Herbalife has been through these pyramid allegations before as I reported with my Seeking Alpha blog post, "Herbalife Short Attack: History Repeats Itself" which is about a short attack which started in 2008 and lasted several months in to 2009. During that short attack, Herbalife's stock plunged 75% from a then share high of $24.375 to a share low of $6.06. The main difference between that short attack and this one is that the 2008/2009 short attack was led by a now convicted felon and this one is being bankrolled by a billionaire hedge fund manager.

Since Mr. Ackman is all about full disclosure, I would like him to answer this one question:

Other than the analysis of the 0.1% eBay sales of Herbalife products, how much real data, including internal consumption and net retail sales analysis from Herbalife's current distributor sales force, did your team obtain in determining that 30% of Herbalife products were internally consumed by distributors and that Herbalife's products were on average sold by distributors at 65% of suggested retail price?

Both of these percentages, 30% internal consumption and 65% of SRP, are extremely important in supporting Ackman's calculations for his illegal pyramid case against Herbalife but my bet is that Ackman's team spent very little time obtaining real data and analyzing actual distributor consumption and retail sales. When you are short 25% of the shares of a company, I guess you aren't as concerned about the accuracy of your numbers, and you just want the numbers to prove your thesis. I think Ackman's team's analysis of Herbalife should be viewed in the context of that old saying "numbers don't lie - people do."

NOTE: I have written two other Seeking Alpha articles on this subject and would encourage people to at least read my article "Herbalife's Nutritional Club Sales Will Take Company To The Next Level" which explains Herbalife's current aggressive plan for distributors to sell even more products to retail consumers.

Source: Insight From A Former MLM Participant Proves Herbalife Is Not An Illegal Pyramid

Additional disclosure: I represent several affiliate companies that help medium to large size businesses and organizations improve their efficiency and reduce the cost of their operations. I am not currently in conversations with anyone from Herbalife concerning my affiliates. However I hope to be able to present information about my affiliates to the management of Herbalife in the future so they too can reduce the cost of their operations and improve profitability. If Herbalife would decide to use the services of one or more of my affiliates in the future, I may receive remuneration from one or more of my affiliates in the future.