Is Herbalife a pyramid scheme? Think of it this way. The Multi-Level salesforce produces economic activity.
a) It recruits participants
b) Its participants purchase product
Whether or not the company is a pyramid scheme depends upon the ultimate fate of the product. Is it:
a) Purchased and consumed by ultimate users outside of the Multi-level salesforce or
b) Is it purchased mostly by those within the pyramid as part of an end-less chain of salespeople chasing recruiting rewards?
More specifically: If you take the retail price that the product is sold for (NASDAQ:RP) and subtract the wholesale cost (WC) you get Gross Profit $ (GP)
RP-WC = GP
If GP > Recruiting Rewards + commissions paid to distributors then the company may be a legitimate MLM. If not the company is likely a pyramid scheme. So...the central questions all market participants have to ask are:
a) How much Retail Sales occur?
b) At what Profit margin do they occur?
c) What is the size of the total profit pool?
d) What is the size of the total commission pool?
e) Is the profit pool big enough to finance the commission pool?
Herbalife wants investors to believe it has lots of customers who generate lots of retail profits and so they are legit. Pershing Square argues that the company generate very few retail sales, that the retail sales that do occur don't produce much material profit, that the profit pool does not cover recruiting rewards, and therefore the company is a pyramid scheme.
In my view, Herbalife misrepresents the true amount of retail sales its MLM salesforce actually produces. In this article, I would like to zero-in on a central piece of Herbalife's (NYSE:HLF) deception and contrast Herbalife's policies to the policies of another MLM, Nuskin (NYSE:NUS).
Nuskin has two key policies that differ from Herbalife. Specifically:
- all distributors must purchase wholesale product directly from the company and,
- all distributors pay the same wholesale price for the product
In contrast, Herbalife's policies allow:
- Junior distributors to purchase wholesale product from Supervisors
- Supervisors to acquire wholesale product for up to 50% less than Junior Wholesalers
I would like to explore the reasons why Herbalife allows intra-distributor transactions while Nuskin does not. As a reminder: Herbalife has different levels of distributorships. Based upon the Volume Points earned, distributors pay different prices for the product.
Sales Leaders (Supervisors and above) get a 50% discount and must buy product directly from Herbalife. Non-Sales Leaders (below Supervisor) pay higher prices for product. At the bottom of the pyramid, an entry level distributor gets a 25% discount. Stated another way, an entry level distributor pays 50% more to buy product than a Sales Leader.
Herbalife does not require Non Sales Leaders to buy product directly from the company. Non Sales Leaders can choose to buy either directly from the company or from their upline Supervisor. When a Junior Distributor buys product from a Supervisor:
1) The Supervisor gets the Volume Points and the Junior Distributor does not.
2) The Supervisor gets a Royalty Override
3) The Supervisor captures 25% commission on the sale.
4) Herbalife only recognizes the Supervisor's COGS in Net Sales
When a Junior distributor buys directly from Herbalife:
1) Both the Supervisor and the Junior Distributor get the Volume Points
2) The Supervisor gets a royalty override
3) The Supervisor captures a 25% commission on the sale.
4) Herbalife only recognizes the Supervisor's COGS on the sale in Net Sales
5) The 25% mark-up is captured off the books in Distributor Allowances.
Q. What is the business rationale behind a company policy that does not require distributors to purchase product directly from Herbalife? Consider the following:
- Each distributor is a separate legal entity
- Supervisors are not HLF employees
- Junior Distributors are not employees of Supervisors
- Junior distributors are told they can succeed at retailing
- Herbalife tells all distributors they can be a success as retailers
Q. Why wouldn't a public company want to capture every single $ of product sold to a junior distributor in its Net Sales account?
Q. Why wouldn't a company expense a commission paid to one independent contractor for a purchase made by another independent contractor?
Q. Why does Herbalife expense Royalty overrides earned on product purchases made by a Supervisor while it doesn't expense commissions paid to a Supervisor on purchases made by a Junior Distributor?
Q. Why does Herbalife do it one way while Nuskin does it another?
Q. Why does Herbalife price discriminate within its salesforce?
The answer is as follows:
When Herbalife allows Junior Distributors to purchase product indirectly from a Supervisor, they create the magical illusion that a retail transaction has occurred. The accounting treatment misleads investors by capturing what is, de facto, a wholesale transaction as if it were a retail transaction. The company also applies inconsistent accounting logic to this chain of events.
Consider the example of a Supervisor who buys product directly from Herbalife. In this transaction, Herbalife captures 100% of the purchase price in Net Sales and 100% of the Royalty override paid to an upline team leader in its Royalty Overrides expense account.
If, on the other hand, a Junior Distributor buys product directly from the company, the company only captures 2/3 of the value of the Net Sale in the Revenue account and does not capture any of the commission paid to the upline Supervisor in its expense accounts.
If Herbalife were applying its Revenue Recognition policies consistently, wouldn't these two transactions be treated consistently? In both instances, upline distributors are being paid a commission for a purchase made by a downline recruit and yet Herbalife uses two distinct accounting rules.
By allowing intra-distributor transactions, Herbalife attempts to obfuscate the true nature of distributor purchases even further. Herbalife's accounting policies and business policies are constructed to achieve one thing - to inflate the appearance that legitimate retail sales are occurring.
This is the only logical business reason the company would not require Junior distributors to order product directly from the company like Nuskin. This is the only logical business reason Herbalife would not want to capture 100% of all wholesale sales made to its independent distributors in its Net Sales account. Nuskin captures 100% of wholesale purchases in its P&L. Herbalife does not.
By shifting this business activity "off balance sheet" so to speak, 4 things occur.
1. Herbalife Net Sales account declines
2. Herbalife's Expense account for Recruiting Rewards declines
3. Herbalife's representation of Retail Sales increases
4. Herbalife's representation of Distributor Allowances/Retail Margin increases
Q. Why would Herbalife want to treat 100% of purchases made by Junior Distributors as if they are retail sales?
A simple analysis of the value chain reveals the answer. Consider a basic transaction where a Junior distributor buys $100 of product from HLF at a 25% discount. Herbalife charges the distributor Sales tax on the product, Shipping and Handling fees and a processing fee. Assume that this Jr. Distributor is able to successfully pass-through 100% of these extra costs plus 100% of the gross margin $ to the retail customer.
Q. What is the Retail Profit?
Q. What compensation is triggered upline on this transaction?
A. For starters, Herbalife pays $25 to the Supervisor as a commission for recruiting the Jr. Distributor. Then, all Sales Leaders upline get Royalty Rewards too.
A simple deconstruction of the HLF value chain makes it absolutely impossible for the Retail Profit on this transaction to finance the recruiting rewards that are paid to all of the Sales People in the upline. Recall: If the Retail Profit pool is less than the Recruiting Rewards pool, then you have a pyramid scheme. (The 50% rule)
Q. How does Herbalife workaround this mathematical problem?
A. It allows its Sales Leaders to fence their products for them.
In effect, Herbalife launders its wholesale transactions to disguise them as retail transactions. Herbalife argues that these intra-distributors arrangements are just "personal consumption" even as it has no proof that this is, in practice, the case.
Also, here's the problem with that argument. If Herbalife allows distributors to buy product at a 25% discount for personal consumption, how are Junior distributors supposed to compete with that pricing as retailers and succeed as retailers?
A. They can't, and so the company misrepresents the true nature of the business opportunity to its new recruits.
And so the circle goes around and around. Herbalife is a deceptive enterprise.
- It deceives prospects as to the earnings potential of its distributorships
- It deceives investors by mischaracterizing wholesale activity as retail activity
- It deceives financial regulators with curious and inconsistent accounting policies
- It attempts to deceive the FTC by inflating its representation of retail sales profits and understating the true value of the recruiting rewards it pays
- It squirrels away recruiting awards in SG&A and Distributor Allowances and Inflates SRP
- It price discriminates against its own sales people rendering the Retail Prospects of its most Junior Salespeople impotent
A company is a pyramid scheme if it relies upon the existence of a greater fool for its sustenance. A company is a pyramid scheme if the retail profits that the company makes on actual sales to customers outside of its sales force cannot finance the sum total of the rewards paid to participants for recruiting.
A simple test of how the money flows when a Junior Distributor makes a retail sale makes it obvious that it is impossible for this small gross margin % to cover all the expenses paid out to the upline, let alone for the Junior distributor to cover his/her own business expenses.
Let's just call that expense something else. The effect of HLF's price discrimination and accounting policies is simple.
1) It Robs Peter at the bottom to pay Paul at the top
2) It allows the company to hide wholesale activity off the books
3) It is central to the nature of the fraudulent activity alleged by Pershing Square and
4) It is a deliberate and elaborate effort to mislead the investing public.
5) It makes it impossible for Junior Distributors to succeed as retailers.
Reductio Ad Absurdum
If Herbalife has lots of retail sales to lots of outside customers who pay its distributors lots of gross margin $ that clearly cover all of its commission expenses, why don't they have reporting systems to prove it? Why such a complicated compensation system? Why such convoluted and inconsistent accounting practices? Why not mandate that all purchases get made through the company so they can be measured and tracked? Why discriminate on price to make it impossible for your salespeople to be successful retailers?
Nuskin is very different from Herbalife.
- Nuskin does not use its salesforce to hide recruiting rewards
- Nuskin recognizes 100% of all wholesale purchases in its P&L
- Nuskin requires distributors to purchase directly from the company
- Nuskin does not price discriminate against its wholesalers based upon purchase volume
- Nuskin asks all Distributors to reveal what kind of distributor they are (eg. Subscription Customer, Distributor, Downline Builder)
- Nuskin treats all Distributors equitably as it applies to their pursuit of the retail opportunity
Nuskin is, quite simply, more transparent than Herbalife with its policies, procedures and accounting practices. Herbalife, on the other hand, basically guarantees that its most Junior Distributors will fail as retailers and uses its Supervisors to help launder downline purchases so they don't look like wholesale consumption.
Herbalife's policies and accounting practices mislead investors and potential recruits alike. Seemingly Mr. Market is starting to see the truth. Herbalife is a Short. Don't be deceived.
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.