I recently wrote an article describing the key errors in Ackman's Herbalife (NYSE:HLF) presentation which lead him to wrongly conclude that the company is a pyramid scheme. Most of these were a result of Ackman and his analyst Shane Dineen's misinterpretation of Peter Vander Nat's definition of a pyramid scheme. Bill Ackman's analyst responded with a series of questions. I have already responded to his conceptual questions/doubts in my previous article. In this article, I am addressing the rest of his questions which deals with taking into consideration Herbalife's wholesale commission, recruiting rewards in S,G&A and Shipping and Handling costs while analyzing if the company is a legitimate MLM organization. I strongly recommend reading my previous articles and Shane Dineen's questions before reading this article. Here are the links:
2. Questions from Bill Ackman's Analyst Shane Dineen (See comments)
I have addressed Shane's Question 2 and 5 in my previous article. In this I will be addressing his Question 1, 3 and 4. Before starting let me remind you, I have used a variable r several times in my previous analysis and this article. It represents percentage of sales of any MLM organization which have actual underlying demand and participants haven't purchased those goods just to be a part of the money making venture. For definition of other variables, please refer to article number 1 mentioned above.
I will start with Question 4, first.
4. How do you incorporate other relevant variables into the analysis, such as (I) wholesale commissions (which "disappear" in Herbalife's income statement above the GAAP Net Sales line item but should be thought of as "upline rewards"), (II) recruiting rewards in SG&A, and (III) distributor expenses (such as the purchase of leads, nutrition club rent, etc…)?
Let's start with a question - how should we account for wholesale commissions which are above GAAP Net Sales line but should be thought as "upline rewards?" It is pretty straightforward to include wholesale commissions in the model. Advanced Retail Commissions (ARC) = Gross Retail Sales - Direct Retail Commissions - Full Production Costs Now Gross Retail Sales = r (Gross Sales) = r (Net Sales + Mark up which distributors charge)
According to Ackman's December 20th presentation
Mark up which distributor charge = Direct Commissions they make on sales to retail customers + Wholesale commissions (on Sale to other distributors)
Substituting it above, we get
Gross Retail Sales = r (Net Sales + Direct Commissions + Wholesale commissions)
= r (Net Sales) + r (Direct commissions) + r (Wholesale commissions)
=r (Net Sales) + Direct Retail Commissions + r (Wholesale Commissions)
Advanced Retail Commissions
= Gross Retail Sales - Direct Retail Commissions - Full Production Costs
= r (Net Sales) + Direct Retail Commissions + r (Wholesale Commissions) - Direct Retail Commissions - Full Production Costs
= r (Net Sales) + r (Wholesale Commissions) - Full Production Costs
= (r - f) W + r (Wholesale Commissions)
Advanced Retail Commissions = (r - f) W + r (Wholesale Commissions)
What does the above equation mean?
r (Wholesale Commissions) denotes Wholesale Commissions which are generated from sales to other distributors which actually have a retail basis (i.e., real underlying demand).
Thus, to the extent these wholesale commissions have actual retail basis, they are totally justified. If r = 100%, then wholesale commissions are getting generated entirely by retail sales even if they are actually going to distributors as distribution rewards.
Think about a situation in which I am a Herbalife Distributor and Bill Ackman is my upline distributor who himself buys a product from the company.
Herbalife => Bill Ackman => Me => Retail Customer
Now, Bill Ackman purchases a product from Herbalife at $50, Bill sells it to me at $60 and I sell it to a retail customer of mine at $75.
I am happy as I have earned my $15 direct retail commission on sales. Bill earned $10 wholesale commission which in this case is totally justified by actual retail sales. This is not much different from P&G selling to a national distributor, who sell to a wholesaler in my city, who in turn sells it a small shop-owner who retails FMCG goods.
Think about another situation in which I am not able to find any retail customer
Herbalife => Bill Ackman => Me => Stuck with the product, no use to me and can't find a retail customer to sell it either.
In this case Bill Ackman purchases a product from Herbalife at $50, Bill sells it to me at $60 and I am stuck with it. I am sad and angry that Bill Ackman and Herbalife took advantage of me and the wholesale commission is not totally justified at all. This wholesale commission will not be a part of ARC fund.
Even Net Sales is multiplied by r while calculating ARC, thus none of the invalid sales enters the ARC fund. Another interesting thing is full production cost of this Package will still be subtracted from the ARC fund even if this sale is considered invalid. This shows how stringent is the criteria which Peter Vander Nat discussed in his paper. And Herbalife, easily passes even that criteria.
Alternative Method Which Will Lead to the Same Results
A second way to think about above derivation is the following. The company has discussed the accounting impact if they start including Wholesale commissions in Net sales as per Pershing's advice.
Reference: Slide 83 of Herbalife's Investor Day Presentation
In this case you can use Advanced Retail Commission's formula mentioned in Peter Vander Nat's paper directly and will still get the same results.
ARC = (r - f")W'
r remains the same, f' decreases and W' increases
f'= (Production Cost)/ W'
W' = W + Wholesale commissions
Substituting, we get,
ARC = (r - (Production Cost)/W') W'
= rW' - Production Cost
= r(W + Wholesale Commissions) - Production Cost
= rW + r (Wholesale Commissions) - Production Cost
= rW - Production Cost + r (Wholesale Commissions)
= (r- (Production Cost)/W)W + r (Wholesale Commissions)
= (r - f)W + r(Wholesale Commissions)
Thus, ARC = (r - f)W + r (Wholesale Commissions) which is same as what we got previously. I hope this very well clears any doubt in your mind on how to take into consideration the impact of wholesale commissions while applying Peter Vander Nat's model.
Now, lets move to your next sub question:
What about recruitment rewards in S,G&A?
Recruitment rewards in any form are classified as upline rewards. It doesn't matter where you place them: Royalty overrides, S,G&A or Wholesale Commissions.
Distribution Rewards = Royalty Overrides + Wholesale Commissions + Distribution Rewards in S,G&A
Now Royalty Overrides numbers are provided by the company ($1,138 million in 2011)
Pershing calculated Wholesale Commissions to be $311 million for Herbalife in 2011 (slide 139 of Ackman's December presentation)
Pershing also calculated Distribution Rewards in S,G &A to be $291 million (slide 146 of Ackman's December presentation). Herbalife has contested this number saying that Distribution Rewards in S,G&A were only $36 million in 2011 (slide 88 of Herbalife's investor day presentation).
I will use both Pershing's estimate and the company's reported numbers to calculate distribution rewards in each case.
According to Pershing's estimates,
Distribution Rewards = $1,138 million + $311 million + $291 million = $ 1,740 million
Let's call them Distribution Rewards (Pershing's Estimates). So,
Distribution Rewards (Pershing's Estimates) = $1,740 million
According to the company's disclosed numbers for recruitment rewards in S,G&A and Pershing's wholesale commissions estimates,
Distribution Rewards = $1,138 million + $311 million + $36 million = $1,485 million
Lets call them Distribution Rewards (Company's Numbers). So,
Distribution Rewards (Company's Numbers) = $1,485 million
Now let us see to what extent Advance Retail Commissions covers distribution rewards in both the cases. Since we are including Wholesale commissions (which is an item occurring above net sales line) explicitly in Distribution Rewards, we have to include it in calculation of ARC as well. I missed it in my calculations in the previous article as I didn't adjust ARC for wholesale commissions, while still continuing to use Pershing's distribution rewards estimates which included wholesale commissions. Here is my modified ARC calculation.
ARC = (r - f) W + r(Wholesale Commissions)
= (0.7 -0.2) 3455 + 0.7 (311)
= $1,945 million
Clearly, ARC of $1,945 million is easily covering all the recruiting rewards in both the cases whether we use Pershing's estimates or the company's numbers. For your information, the necessary requirement is that ARC should cover at least half of the distribution rewards.
Let's move to Shane's first question now.
1. Why have you included Shipping and Handling revenues and literature and promotional revenues in your calculation of "W," which you equate to Herbalife's reported GAAP Net Sales? Because these items are, in fact, distributor expenses, shouldn't you exclude them from your calculation of W?
I will discuss how to include Shipping and Handling revenues in my next article (Part 3). However, for the time being let us do as you are suggesting and exclude them from the calculation of W. Here are the results:
Net Sales (sans Shipping and Handling and literature and promotional revenues)
= Reported Net Sales - Shipping & Handling - Literature and Promotional Revenues
= $3,455mm - $510mm - $173mm
= $2,772 million
Advanced Retail Commissions in this case
= (0.7 - 0.2) 2722 + 0.7 (311)
= $1578.7 million
This is still completely covering $1,485 million of Distribution Rewards (Company's Estimates).
Now let's see what happens if we take Distribution Rewards (Pershing's estimates):
Distribution Rewards (Pershing's Estimate) = $1740 million
Advanced Retail Commissions = $1578.7 million
Effective Recruitment Rewards (ERR)
= Distribution Rewards - Advanced Retail Commissions
= $1740 - $1578.7
= $161.3 million
You can see that even in this scenario, Effective Recruitment Rewards are just 9.3% of total distribution rewards. To call an MLM organization "primarily based on recruitment" this number should be greater than 50% according to Peter Vander Nat's paper. Of course the word "primary" is open for interpretation, but this is not a borderline case as I have explained in my previous article.
Now let's visit the erroneous calculations you have presented in Question 3.
3. Correcting for the exclusion of distributor expenses from GAAP Net Sales and inclusion of SG&A into "full production costs" yields a very different calculation of ARC. Based on your numbers, ARC is $1,740mm. However, correcting for #1 and #2 above, ARC is only $185mm.
['W' = GAAP Net Sales ($3,455mm) - S&H ($510mm) - Lit/promo ($173mm) = $2,772mm;
"Full production costs" = COGS ($680mm) + SG&A ($1,075mm) = $1,775mm;
"Full production costs" / 'W' = $1,775mm / $2,772mm = 0.63;
Therefore, ARC = (0.7 - 0.63)W = 0.07 * $2,772mm = $185mm]
In light of the fact that the ARC calculated above is only a fraction of "upline rewards," why wouldn't you conclude that Herbalife is a pyramid scheme?
I have already explained in my previous article that "f" refers to direct production cost and Peter Vander Nat never said that full S,G&A should be included in its calculation. All MLM companies including Tupperware (NYSE:TUP), Avon Products (NYSE:AVP), Nuskin (NYSE:NUS) and USANA (NYSE:USNA) will be classified as a pyramid scheme. However, let me point out some of the fundamental errors you are making in your calculation.
You claimed that there are $291 million of recruiting rewards in S,G&A. Advance Retail Commissions is a concept to check if recruitment rewards can be taken care of by funds generated from retail sales. Including S,G&A in full production cost will mean you have already subtracted this amount (which Advance Retail Commissions was supposed to provide for) at the time of calculating Advanced Retail Commissions. You are counting it twice.
Also, when you are excluding Shipping and Handling revenues from Net Sales, you cannot include Warehouse and Supply Chain expenses from S,G&A in direct production cost. Even direct freight cost in COGS needs to be excluded.
Frankly, if we start including S,G&A in direct production cost, then any company which has ever made any loss in its history will be classified as Pyramid Scheme. Think about it.
Alright, we are done for the most part. Let's see what is remaining?
You asked what about purchase of leads and nutrition club rent?
For nutrition club rent, I will suggest you going through this video of Bill Ackman in which he is discussing finance basics. He gives an example of Bill's lemonade stand in which he makes losses in his first year. Then he makes some assumption of volume/price growth and bam! ... the business becomes highly profitable over the next few years (on an excel sheet of course). Now, it's not that simple in real life. But if a nutrition club is providing some additional source of income for distributors and a place for obese people to meet their support group, I don't see where the problem is. In fact, Herbalife's rules regarding the nutrition club ensures the cost remains relatively low. Nothing fancy required.
Regarding purchase of leads, the company is not selling it and neither any money from it is going to the company. In fact, the company is taking action against its distributors who are indulging in activities like these, even if they belong to the top tier in hierarchy.
So Shane, we are done with your questions. Now a Few Questions to you:
- Peter Vander Nat was a senior economist with FTC and he has fought against pyramid schemes his whole life. His model discusses very stringent criteria about overall stability of an MLM organization. You yourself have mentioned/quoted him on the top of your website on Facts about Herbalife. Now that you know you have misinterpreted his work and Herbalife easily passes the stringent criteria he laid in his paper (which was the basis of your pyramid "proof"), when are you covering your short?
- Will you still keep shouting from the roof top that the FTC should start an investigation on Herbalife for being a pyramid scheme? Because if the FTC starts an investigation and you cover your stock while the investigation is still going on, it would essentially be a market manipulation. You presented misleading analysis, misguided other investors, created fear by literally coercing government agencies to investigate a company which you know is not a pyramid scheme, thus causing its stock to decline and profiting from the short sale. I am sure you now understand that Herbalife's stock is not going to zero and you are smart enough to know that if you wait until FTC investigations are over, you will have to cover your shorts at a significantly higher price.
- Why do you think the FTC will cooperate with you in manipulating the stock price of a publicly listed company?
- Is it true that you spent 18 months analyzing Herbalife?
- Where are you hiding?
Additional disclosure: The article was written with substantial inputs from an investor who has a long position in “in the money” call options of Herbalife. He may size up / exit / re-enter his position at any time.