Herbalife (HLF) is a short. Management misleads investors, the company churns out distributors at a dizzying pace, and the logic they present to the marketplace simply doesn't add-up. Like the Mad Hatter's Tea party in Alice in Wonderland, many of Herbalife's representations are nonsense.
This article uses Herbalife's own data and verbal and written disclosures to debunk its own representations. Herbalife Management wants investors to believe two things:
a) That the company has 5.7 million outside customers in the U.S. who purchased twice in 2012 according to research conducted by Lieberman i.e. it has lots of retail customers
b) That most of the company's distributors are not really distributors but rather discount customers. Specifically, Herbalife tells investors that they are not really signing-up for the "business opportunity" but are just like Costco (COST) customers buying for the discount. i.e even more retail customers
These are the two truths we are told to accept by the company to escape the assertion that they are a pyramid scheme.
Q. Are they bluffing or not?
On January 10, Herbalife executives made a presentation to refute claims by Pershing Square that it is a pyramid scheme. During this presentation, Herbalife gave investors some very interesting and decidedly critical data points.
Herbalife told us the following
- Lieberman research claimed 5.7 million U.S. households purchased Herbalife Products twice in 2012
- Lieberman told us Herbalife had 480,000 Active U.S. Distributors in 2012 (Distributors who placed an order = Active)
- so, 480,000 of the 5.7 million households that purchased were distributors or less than 10% of households that purchased Herbalife product
- Herbalife also Direct Shipped 1.4 million orders to 460,000 Unique Addresses that were not Distributors
- Assuming each address as a proxy for a single customer, 460,000 of the 5.7 million households were Direct Shipped
- The remaining households, therefore, must have been serviced by Distributors using simple algebra where A+B=C
- Direct Ship Orders accounted for 31% of Total Orders and 32% of Total Volume
- All remaining Orders were shipped directly to Herbalife's Active Distributors
Herbalife also tells us the following about its Active Distributors
- During a Morgan Stanley Investor Presentation in November, Herbalife stated that 80% of Distributors do not have a downline.
- During an interview on CNBC now well documented, CEO Michael Johnson stated that 90% of Herbalife distributors buy "for a single reason - self consumption."
Using these data points we can reasonably determine what HLF's business looks like according to Herbalife itself and we can test the veracity of Herbalife's representations.
Herbalife's Total U.S. Business in 2012
- 1.4 million orders /31% = 4.5 million orders
- 1.4 million orders x 260 Volume Points = 364 million VP
- 364 million VP/32% = 1,137 million Total VP
Bucket A - Product Direct Shipped (Herbalife Gives us this Data)
- 1.4 million orders sent to:
- 460,000 unique addresses/non distributors
- 364 million Volume Points
- 791 Volume Points Per Household
- 1 VP/1.4 = $1
- $565 per household
- HLF does not tell us if this product is shipped at a discount or not
Bucket B - Product Shipped to Distributors
- 4.5 million orders - 1.4 million orders = 3.1 million orders
- 1,137 million VP - 364 million VP = 773 million VP
- 773 million VP/480,000 Active Distributors = 1,610 Volume Points per Distributor
- 1,610 VP/1.4 = $1,150 per distributor at wholesale cost
So, Distributors ordered roughly 2x the Product to their homes to service 4.7 million customers than was Direct Shipped to 460,000 outside Customers.
- The ratio of Distributor Shipped Product to Direct Shipped Product = 2:1
- The ratio of Distributor Served Customers to Direct Shipped Customers = 10:1
Herbalife wants us to believe that Direct Ship Customers buy at least 5x more product than the 4.7 million customers who are supposedly serviced by Distributors. But wait, there is more. Herbalife also tells us categorically that 90% of distributors have no downline/self-consume.
Q. If 460,000 households get 1/3 of the product and 480,000 Distributors get sent the other 2/3rds of the product and 90% of these folks buy for a single reason, to self-consume.
a) where are the other 4.7 million outside customers? and
b) who is selling to them?
The answer, of course, is a simple plug if what Herbalife says is true. If 90% of Herbalife distributors only self-consume then only 10% can actually distribute.
- 10% of 480,000 Active distributors is 48,000 people.
Herbalife wants us to believe that 100% of the 5.2 million outside customers the company supposedly has is being serviced by these 48,000 "chosen" distributors and that the other 432,000 distributors are just "retail customers" buying at a discount. Herbalife wants us to believe that 48,000 Distributors have an average of over 100 customers each while 432,000 Distributors have an average of 0 customers each.
Herbalife wants us to believe that 432,000 people are smart enough to sign-up with Herbalife for a 25% discount for self-consumption while 5.2 million other people are stupid enough to pay full SRP through one of 48,000 distributors. Herbalife wants us to believe that the average product sent to the 480,000 active distributors is $1,150 but that most of these folks aren't even trying to pursue the business opportunity.
Q. Why would Herbalife want us to believe this?
The answer is obvious:
Herbalife has no management reporting system to prove that the company makes actual retail sales at full SRP and the lack of proof of retail sales is a critical variable in judging Herbalife a pyramid scheme.
If the mark-up on sales made to actual retail customers outside of the pyramid can finance the cost of the recruiting rewards paid to upline distributors within the pyramid, no pyramid scheme.
If not, then the recruiting rewards are financed by internal consumption and so you have a pyramid scheme. So, back to Herbalife's representations.
If Herbalife argues that distributors self consume it can try to argue that sales made to distributors should be counted as retail sales. It can then try to argue that the wholesale margin should be counted not as a recruiting reward but rather as a retail reward.
It can then try to argue that the percentage of compensation related to retail activity v. recruiting activity is reasonably balanced. Follow?
Herbalife has an incentive to inflate its representation of "retail sales" to avoid the idea that it is a pyramid scheme. Why else would it be working so hard to convince us all that distributors are just customers even as the legal precedents reject this argument?
If, on the other hand, most of the HLF distributor base are people trying their hand at the business opportunity, clearly most of the product ordered is for resale purposes, cannot be considered retail consumption, and therefore the wholesale mark-up that gets paid out to supervisors must be considered a recruiting reward.
Q. Which of the following scenarios seems more likely to you?
Scenario A - The Herbalife Story
- Herbalife has 480,000 Active Distributors but only 10% of them sell, the rest self-consume
- 31% of orders are direct shipped to 460,000 legitimate customers
- The other 4.7 million customers are serviced by 48,000 distributors or an average of 100 customers each.
- 432,000 distributors are really just smart customers who buy for a 25% discount
- the other 5.2 million outside ordinary customers pay full price to an elite group of 48,000 Distributors, including 460,000 who get Direct Shipped.
- 90% of the distributors bought the IBP to become Inactive/never sell the product
- 10% bought the IBP to pursue the business opportunity.
- All of the people who are trying to lose weight on Herbalife shakes are located in low-income nations/communities around the world.
- Low income people are spending over $500 a year to buy a high-priced nutrition product to help themselves try to lose weight
Scenario B - The Pershing Square Story
- Herbalife has 480,000 Active Distributors in the USA
- Most of them are trying to pursue the HLF business opportunity
- Most of them buy product to try to gain Volume Points towards qualification for Supervisor. The average amount of product ordered is around $1,150.
- The Herbalife pyramid scheme encourages the purchase of Volume Points to secure discounts and royalty overrides.
- Most self-consume some portion, try to resell some portion, and many try to recruit to move-up the ladder.
- Many get stuck long excess inventory.
- Most Non Sales Leaders fail at the business opportunity in less than a year because the market is saturated and so they can't reach the Supervisor level.
- It is unlikely Herbalife has 5.2 million retail customers because so many distributors churn out because they can't find customers
- 50% of Sales Leaders fail every year
- Most failed distributors absorb an economic loss
As a result, Herbalife has to recruit over 1.5 million new distributors every year just to perpetuate the pyramid scheme. What does common sense lead you to believe?
Herbalife's arguments to the investing public defy logic and reason. They ask us to believe in fantasies and fairy tales that simply cannot be true.
They ask us to believe that 460,000 people buy IBPs exclusively to get a discount while 5.2 million people do not. They ask us to believe that 100% of the so-called Lieberman retail customers are being serviced by less than 10% of their distributors.
They ask us to believe that distributors who sell have 100 customers on average while those who supposedly self-consume have 0 customers. They ask us to believe that 432,000 people have 0 customers while 48,000 people have 5.2 million customers.
Nonsense. All of it! Bill Ackman and Pershing Square are all-in on their Herbalife Short. I am with them all the way. Herbalife's story simply doesn't add-up.
Herbalife wants us to believe that Herbalife distributors are just self-consumers - rational agents trying to drop a few pounds. Pershing Square argues that they are failing distributors victimized by the pyramid scheme.
As you look at the math and statements made by the company's executives since the beginning of January what makes the most sense to you? Perhaps this exchange between Mr. David Einhorn and the company will push the argument over the top? Let's go back to Herbalife's Q1 conference call from 2012. David Einhorn asked the CFO the following:
Okay, good. One last question. When you had your previous 10-K, you disclosed 3 groups of distributors at the low end. You called 29% self consumers, 57% smaller retailers and 14% potential Sales Leaders. And then that disclosure did not repeat in the subsequent 10-K. So I've got 2 questions. First of all, how do you track that and how do you characterize and know which ones are which? And second, why did you stop disclosing that in the last 10-K? Is that something that you've stopped tracking or just stopped disclosing?
John DeSimone - Chief Financial Officer
This is John. The criteria for grouping distributors into different classes was based off of their volume purchases. And we make assumptions that people below a certain volume weren't doing the business, they were buying for self consumption. And I don't remember the exact amounts but I can get it to you after the call. It's how we delineated between the 3 classes. One of the reasons we took it out of the 10-K is a change in CFO from Rich to me, I didn't view it as valuable information to the business or to the investors. However, we can easily provide the exact same breakout going forward if you like. I could email it to you and to our investors. Again, I don't remember the exact delineation between the 3 classes but I can certainly get it to you. Our objective is to be completely transparent.
Q. How does Herbalife conclude that 90% of distributors are just self-consuming?
A. They make it up! They make an assumption based upon Volume of business activity.
Q. Why do they make it up?
A. To inflate their representations of a "retail sales" account.
From there they leap to the conclusion that 90% of sales to distributors are, in practice, retail sales. However, for that to be true all of the articulated 5.2 million outside customers must, by process of elimination, be serviced by only 48,000 distributors, perfectly situated geographically around the country.
Is Herbalife in Wonderland? Or does it tell more fibs than Pinocchio? If you don't think you are being mislead, answer the following question.
If 90% of HLF's low-income distributors love the product so much they sign-up to get a 25% discount on $500 worth of weight loss product for self-consumption, why do so many of them churn out in less than a year? If Herbalife offers a 25% discount to those who wish to self-consume, why aren't there 4.7 million distributors and 480,000 outside customers and not the other way around?
Or maybe, just maybe something else is going in? Pershing Square spent a year figuring it out. But as they have said ... "Sunshine is the best disinfectant." My bet, the FTC won't be far behind.
Disclosure: I am short HLF.