As a longtime entrepreneur and business owner, I can understand the allure of the Herbalife (NYSE:HLF) Nutrition Club. Distributors are able to launch their own establishment with minimal upfront investment. Combine that with the assurance of riches from their mentors and many see the business opportunity as the chance of a lifetime.
The addition of Nutrition Clubs to Herbalife's selling model has provided Herbalife with the potential to dramatically increase revenue and provide it with its most essential success catalyst-its ability to recruit new distributors and increase the retention rate of current distributors.
It was no surprise that the clubs were a major focus for Herbalife during its analyst presentation on January 10th. While Bill Ackman presented some less than desirable photos of Nutrition Clubs during his "Who Wants to Be a Millionaire" presentation, Herbalife responded with a heartwarming video to show that you can't really judge a club by its cover.
Ackman presented some of the onerous restrictions placed on club owners (as discussed in the next section), yet in our opinion he failed to unearth what we believe is a significant concern - the legality of the Herbalife Nutrition Clubs.
If you want to open a Herbalife Nutrition Club you need to abide by an exhaustive list of rules and regulations. Yet, they are also sure to note that distributors are independent business operators and that Herbalife does not "approve, endorse, authorize, guarantee or assume any obligation with regard to Nutrition Clubs".
With that noted let's highlight some of the key points in the Herbalife Nutrition Club Rules:
1. Nutrition Clubs are not franchises
2. Nutrition Clubs are not restaurants or carry-outs
3. Nutrition Clubs are not food service establishments
4. Nutrition Clubs are not retail stores
5. Nutrition Clubs cannot post prices for products but may charge a membership fee
6. Nutrition Clubs may keep inventory on hand and may sell product at retail
7. Nutrition Club owners must deface or destroy product labels and containers before disposing in order to protect against counterfeiting
8. Nutrition Clubs must cover the windows so that the interior of the club is not visible from the exterior
9. Herbalife instructs distributors that all opened products must be consumed on club premises.
10. Herbalife instructs distributors that any opened product cannot be removed from the club. Following these instructions, distributors are given the false information that: "This is a key differentiation from operating a retail location, which is not allowed".
11. Herbalife's Nutrition Club Manual is 32 pages; yet devotes a mere 54 words describing regulatory requirements, i.e., business, tax and health permits and/or licenses in connection
12. Open/Closed sign cannot be visible from the exterior.
13. Clubs cannot advertise on radio or television
Why is Herbalife Concealing its Nutrition Clubs?
The aforementioned club rules are just a sample of the restrictions placed on distributors who run Nutrition Clubs. Some of the restrictions are just plain laughable:
At first blush I thought Herbalife enacted the above procedure to ensure concealment of Nutrition Clubs from the public and regulators. Good for Herbalife for taking all steps necessary to ensure that bands of dumpster divers don't have an opportunity to find an empty Herbalife product container, which could obviously be used for the illicit purpose of counterfeiting Herbalife's products.
Well, there you have it! Nutrition Clubs are NOT retail stores or outlets. This is curious, given the fact that "Club operators may keep product inventory on hand, and they may sell their inventory at retail".
So, just to be clear, a Nutrition Club is not a retail store, but a club may sell inventory at retail.
Please note this exchange between top sales leaders Amber Wick and Mary Holloway at the Herbalife Nutrition Training Seminar at Herbalife Extravaganza 2011: (note these comments are made with the Vice President of Global Ethics and Compliance Frank Lameberti sitting on the stage)
AMBER: When we say we're not a retail establishment, does that mean that we cannot retail out of the establishment? No. It means that when we walk in the front door, we don't necessarily want it to look like a retail smoothie shop.
This is a building where we do many things….it doesn't mean though that we don't retail out of the nutrition club. In fact, it is that we want you to retail.
We don't want it to look like exclusively like a RETAIL smoothie shop because it's not. There are so many more things that are done inside of the building. But I hear sometimes that people don't necessarily want to retail out of the nutrition club.
Well we do wellness profiles at a table, one on one presentations…where people walk out with their program.
MARY: But they didn't go to the shelf to pick it up. We had it in the back, and we just go pull it in the back from our cabinets and bring it out front and write up on it and get em going on the products.
Herbalife explicitly says that a Nutrition Club is "not a retail store or outlet". You also "may not operate on the premises of retail establishments".
But according to Amber and Mary as stated above, you can 'hide' the product in the back room and bring it out when someone wants to buy it. It's clear that Nutrition Club owners are selling product, they just don't want anyone to know about it.
The big question: Why would Herbalife go out of its way to conceal the fact that they are actually retailing products from these locations?
It is in our opinion that Herbalife is intentionally attempting to conceal the fact that these are "retail operations" because of the increased scrutiny and obligations that Herbalife would be
Note that Herbalife is also quick to distance itself from any association with the word 'Franchise'. From Jon Taylor, a noted MLM expert:
"Are MLMs franchises? Though many promoters refer to their MLMs as ―like a franchise or as an―unfranchise- or even as a ―personal franchise, the last thing MLM executives want is to have to comply with franchise disclosure requirements, including a franchise disclosure document that could be hundreds of pages long with financial data, background of founders, etc."
In one look at the requirements of the Franchise Disclosure Document, it's clear that there are many disclosures that Herbalife would rather avoid -- especially point 19, which relates to Financial Performance Representations.
While we are less concerned about the Franchise issue, Herbalife is concealing the fact that they are operating Retail Food Establishments because they are fully aware that they are in violation of FDA, state and local laws and regulations.
According to the FDA's Food Establishment Safety Guidelines, a "Food establishment" is an operation that "stores, prepares packages, serves, vends, or otherwise provides food for human
They also state that "A private home, a room used as living or sleeping quarters, or an area directly opening into a room used as living or sleeping quarters may not be used for conducting
Food Establishment operations."
Herbalife is headquartered in California. This is from the California Retail Food Code:
Q: Can I prepare food in my home for sale to others?
No. In California all food that is intended to be sold to the public, must be prepared in an approved commercial food preparation facility. Such facilities cannot be connected directly to a private residence.
Q: Who needs a Permit to operate a food facility?
Any person, business, or organization that prepares, sells, or gives away food to the public needs a permit…operator…must show that the facility meets minimum requirements of the California Retail Food Code.
The picture above represents a typical nutrition club, where distributors serve shakes to customers, prepared in a blender and made with milk.
Milk is defined by the FDA as a "potentially hazardous food" and therefore requires stringent guidelines relating to the preparation and storage any foods served using milk as an ingredient.
Watch Dr Luigi Gratton prepare a Formula One shake with milk (the recommended way of preparation).
And, remember, according to the FDA, a distributor preparing and selling shakes to clients from their home would be in violation of the laws:
A private home, a room used as living or sleeping quarters, or an area directly opening into a room used as living or sleeping quarters may not be used for conducting food establishment operations.
Retail Selling Establishments
A Retail selling establishment is a fixed location from which a person sells products and services; as opposed to direct selling (the model Herbalife uses) which is the sale of products or
services person-to-person away from a fixed location.
State; City; County and/or federal regulatory agencies impose numerous regulatory requirements on retail selling establishments. These requirements include, but are not limited to, business licenses; zoning approval and physical location requirements such as number of parking spacing and fire and safety code compliance. Additionally, operators of retail selling establishments must procure the appropriate retail sales tax license and remit the requisite sales tax to the appropriate licensing authority.
I contacted my local regulators and found that opening a Nutrition Club wouldn't be a walk in the park as Herbalife suggests. I was advised to find a location and submit plans -- showing sq. ft., parking, accessibility, fire protection, bathrooms, etc. If it met zoning and building requirements, my next steps would involve obtaining license board and health department approval.
Herbalife informs distributors (1) they are permitted to operate a Nutrition Club from a home or office and (2) the retail sale of unopened products does not give rise to the Club meeting the legal criteria of a retail selling operation. In fact, according to its Corporate Nutrition Club manual, only the sale of opened products would cause clubs to meet the criteria of retail selling operations.
Herbalife's directive to "acquire any necessary licenses" does not constitute clear notice that licenses and other regulatory requirements must be met before a distributor can operate a Nutrition Club.
Clear notice would be something like:
LICENSES MUST BE OBTAINED AND REGULATORY REQUIREMENTS MUST BE MET BEFORE A DISTRIBUTOR CAN OPERATE A NUTRITION CLUB
(NYSE:A) Contact the appropriate local, state or federal government agencies in order to acquire all necessary business, tax and health permits and/or licenses.
(NYSE:B) Distributors must submit proof to the company that she/he has obtained all requisite licenses, health permits and fulfilled all regulatory requirements before commencing operation of a Nutrition Club.
(NYSE:C) Distributors cannot operate a Nutrition Club from (1) a private home; (2) a room used as living or sleeping quarters; or (3) an area directly opening into a room used as living or sleeping quarters.
(NYSE:D) Distributors cannot operate a Nutrition Club from an office or any other commercial location until she/he has obtained all requisite licenses; health permits, inspections and approvals.
We believe that Herbalife is intentionally concealing the existence of its home based and commercial nutrition clubs. This is due to our belief that a significant portion of Herbalife's home and commercial based nutrition clubs are in violation of FDA and local, state, city and county laws.
We believe that the authorities have the legal right to shut down each and every non-conforming Herbalife Nutrition Club in existence until the clubs are 'up to code' in regards to obtaining the appropriate permits, licenses, training and equipment.
We believe that the average time for the typical commercial Nutrition Club to get "up to code" would take between roughly 6 months to 1 year. This would lead to a significant disruption in Herbalife's current business model.
We also believe that Herbalife at some point (due to its onnerous club rules and regulations) could be forced to become a franchisor to these stores, in turn potentially changing the entire business model for Herbalife.
It is important that investors realize the extent that Herbalife has gone to conceal what is supposedly the future of the company.
While the legality of the clubs is not our only concern with Herbalife (please read our first, second, and third report on HLF for more details), we believe that it should be a major concern for all investors.
Many believe that the only legal action that Herbalife might potentially face would be via the FTC or the SEC, yet we believe that the legality of its Nutrition Clubs should be front and center as part of the entire debate surrounding this company.