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In a recent article titled "Shattering the Personal Consumption Myth" I outlined how no rational individual would actually sign-up to be come an Herbalife (HLF) distributor to acquire Herbalife product at a discount for personal consumption. Rather, the only rational reason to pay $59 to acquire an IBP and to load-up on Inventory would be to pursue the "business opportunity" and to load-up on enough merchandise to "buy your discount", and to pursue the dream.

Nonetheless, Herbalife longs and the company continue to cling to the irrational notion that 71% of Herbalife's distributors are just "discount customers".

In this article, I would like to further deconstruct the mythology that Herbalife is a legitimate business to demonstrate, categorically, that the reason Herbalife is a pyramid scheme is because it is an endless chain. And therefore, it is inevitable that the business must ultimately fail, disappoint those at the bottom of the scheme, and therefore should be shut down.

Today, on the news that Carl Icahn has invested in a 14% of Herbalife's common equity with an option to increase this stake, Herbalife's market cap has surged over the past few days to $4.4 billion or roughly 9x eps guidance.

Considering the fact that 30 million shares are short, the company is buying back stock and 14% of the float is now in friendly hands, this isn't exactly a squeeze of epic proportions. This begs the question: What is Mr. Market seeing that long investors like Mr. Icahn are not?

The answer is clear.

Herbalife is a company on spin cycle because its entire business model depends upon recruiting and therefore is an endless chain.

In this article I would like to explore a number of metrics that demonstrate that there is no productivity nor leverage in Herbalife's marketing efforts.

First, let's look at Net Sales per Distributor for the past 5 years.

In 2008:

  • Herbalife produced $2.4 billion of Net Sales
  • Ended the Year with 1.9 million distributors
  • Avg. Net Sales Per distributor was $1,263

In 2009:

  • Herbalife produced $2.3 billion in Net Sales
  • Ended the Year with 2 million distributors
  • Avg. Net Sales Per distributor was $1,150

In 2010:

  • Herbalife produced $2.7 billion in Net Sales
  • Ended the Year with 2.1 million distributors
  • Avg. Net Sales Per Distributor was $1,285

In 2011:

  • Herbalife Produced $3.5 billion in Net Sales
  • Ended the Year with 2.7 million distributors
  • Avg. Net Sales Per Distributor was $1,296

In 2012:

  • Herbalife Produced $4.0 billion of Net Sales
  • Ended the Year with 3.1 million distributors
  • Avg. Net Sales Per Distributor was $1,290

This data series shows that there is a linear relationship between the number of distributors and the topline sales that the company generates. Effectively, the growth in the topline is correlated 1:1 with the growth in the number of distributors recruited.

Q. What are the implications of this data?

The 80/20 rule does not seem to apply in the Herbalife world. If 20% of distributors were driving 80% of Net Sales, we would expect to see Avg. Net Sales Per Distributor decline over time. Effectively, the impact of a new recruit on the Net Sales of the company would be non-linear. That is to say that the new recruit would account for a smaller percentage of the company's Net Sales v. those who have participated in the scheme for longer. This is not what the data reveals.

Rather, the data shows that the purchases of product per distributor remains the same as the base of the pyramid expands.

This also supports the conclusion that growth in Net Sales is driven by recruitment v. by the ongoing service of existing customers plus additional recruits.

Can we construct additional evidence to support this assertion?

I would like to introduce a new metric to determine Herbalife's reliance upon recruiting. This metric is Net Sales (NS) divided by New Recruits (NR). Effectively this is a productivity metric.

If Herbalife's recruiting efforts are successful at building a franchise business than the value of NS/NR increases over time. Effectively, the higher the value of NS/NR over time the less topline sales is dependent upon recruiting.

If not, then the business is on Spin Cycle

  • Let's call Net Sales NS
  • New Recruits NR
  • Net Sales Per Recruit X

Then, what I would like to do is compare the variable Y in a time series. So, let's call it X1, X2, X3, X4, etc.

If X2/X1 > 1 then Herbalife's business is not dependent upon recruitment to sustain its topline growth because it retains customers.

If X2/X1 =< 1 then Herbalife's business is dependent upon recruitment to sustain its topline.

Let's use the data from 2008 - 2012 to examine this variable.

For 2008:

  • Net Sales = $2,359,213
  • New Recruits = 1,145,815
  • NS/NR = $2,059
  • X1 = $2,059

For 2009:

  • Net Sales = $2,359,213
  • New Recruits = 1,151,349
  • NS/NR = $2,019
  • X2 = $2,019

For 2010:

  • Net Sales = $2,734,226
  • New Recruits = 1,320,473
  • NS/NR = $2,070
  • X3 = $2,070

For 2011:

  • Net Sales = $3,454,537
  • New Recruits = 1,674,627
  • NS/NR = $2,062
  • X4 = $2,062

For 2012:

  • Net Sales = $4,072,330
  • New Recruits = 1,958,080
  • NS/NR = $2,079
  • X5 = $2,079
  • X1 = $2,059
  • X2 = $2,019
  • X3 = $2,070
  • X4 = $2,062
  • X5 = $2,079

In 2008 Herbalife recruited 1.1 million distributors. In 2012 Herbalife recruited nearly twice as many distributors or 1.96 million distributors. In 2008 Net Sales were $2.3 billion. In 2012 they were $4 billion.

Yet, even as the company has doubled in size, the $ Value of Net Sales per new recruit has remained flat over the past 5 years.

  • X2/X1 = .98
  • X3/X2 = 1.02
  • X4/X3 = .996
  • X5/X4 = 1.008

This linear relationship also tells us that those advancing the 80/20 rule argument is bunk. If 20% of Herbalife distributors were driving 80% of sales we would expect to see Net Sales per New recruit increase over time. Instead, we do not.

Also, consider the case of a company that retains 100% of the customers it recruits each and every year.

Q. What would X2/X1 look like?

Say the company recruits 1 million customers in Year one then another 1 million in Year 2 and then 1 million in Year 3. 1 million in Year 4. and another 1 million in Year 5.

Assume that each new recruit drives $2,000 in sales. Assume further 100% of customers are retained.

In year one the business has $2 billion in sales. Sales per new recruit is $2,000.

By the end of 5 years the business has $10 billion in net sales but Net Sales per New Recruit is $10,000.

Why?

The stronger a company's retention rates the Higher the value that X will be.

A company that retains more customers than it recruits YOY will show a higher X value than one with a retention problem.

Effectively, the slope of the line created by the variable X will be positive.

Ostensibly, Carl Icahn thinks he has acquired a growth company. However, on a productivity basis he has acquired a company on Spin Cycle.

Observing X as a productivity variable reveals that Herbalife's growth is not driven by sustainable and healthy customer retention metrics but rather by the company's ability to find new customers to "try" the opportunity.

Now, let's introduce a new variable. Let's call this variable Y.

  • Y is the Net Sales per Distributor who resigns.

From 2008 to 2012, here is the data that tell us how many Distributors resigned from Herbalife.

For 2008:

  • Herbalife was in 65 Countries
  • Opening Distributors 1.7 million
  • New Recruits 1.15 million
  • Closing Distributors 1.9 million
  • Churn 950k
  • Net Sales - $2.4 billion
  • NS/Churn = $2,526
  • Y1 = $2,526

For 2009:

  • Herbalife was in 70 countries
  • Opening Distributors 1.9 million
  • New Recruits 1.15 million
  • Closing Distributors 2.0 million
  • Churn 1.05 million
  • Net Sales - $2.3 billion
  • NS/Churn = $2,190
  • Y2 = $2,190

For 2010:

  • Herbalife was in 72 countries
  • Opening Distributors 2.0 million
  • New Recruits 1.32 million
  • Closing Distributors 2.1 million
  • Churn 1.22 million
  • Net Sales - $2.7 billion
  • NS/Churn = $2,213
  • Y3 = $2,213

For 2011

  • Herbalife was in 74 countries
  • Opening Distributors 2.1 million
  • New Recruits 1.67 million
  • Closing Distributors 2.7 million
  • Churn 1.07 million
  • Net Sales - $3.5 billion
  • NS/Churn - $3,271
  • Y4 = $3,271

For 2012

  • Herbalife was in 79 countries
  • Opening Distributors 2.7 million
  • New Recruits 1.96 million
  • Closing Distributors 3.1 million
  • Churn 1.56 million
  • Net Sales - $4 billion
  • NS/Churn - $2,564
  • Y5 = $2,564

To summarize, Net Sales (Y) per distributor who resigned starting in 2008 is:

  • Y1 = $2,526
  • Y2 = $2,190
  • Y3 = $2,213
  • Y4 = $3,271
  • Y5 = $2,564

Q. What would we expect this time series set to look like for a company with strong retention rates?

Using common sense, we would expect this data series to have a positive slope too. As the number of customers who churn out over time becomes a smaller percentage of the overall customer base, Net Sales per distributor who resigns would increase.

However, as we can see from Herbalife's data with the exception of 2011 when Herbalife expanded into 5 new countries geographically, Herbalife's Net Sales per distributor who resigns is basically flat from 2008 to 2012.

Y5/Y1 = 1.015

Finally, what happens when we compare the two variables X and Y?

If X is the Net Sales per recruit and Y is the Net Sales per churnout, what do these ratios look like starting in 2008 (X1)?

  • X1:Y1 = $2,059:$2,526 = 80%
  • X2:Y2 = $2,019:$2,190 = 92%
  • X3:Y3 = $2,070:$2,213 = 94%
  • X4:Y4 = $2,062:$3,271 = 63%
  • X5:Y5 = $2,074:$2,564 = 80%

What do these ratios tell us?

1) The closer this ratio gets to 100%, the closer Herbalife's business model gets to contracting.

2) 2011 was an anomaly v. the other years in the time series. 2011 was a year when Herbalife expanded into 5 new countries.

3) The average ratio is 82%. This ratio implies that Herbalife has to replace 80% of its Sales Volume each and every year with new recruits.

Since 2008, Herbalife has churned out 5.95 million distributors while the company's geographic footprint has expanded from 65 countries to 88 countries (+35%). Net Sales have increased from $2.4 billion to $4 billion (+67%). Total Distributors has increased from 1.7 million to 3.1 million (+80%).

Over the same time frame:

  • Net Sales per Distributor has remained constant at $1,263 in 2008 v. $1,290 in 2012.
  • Net Sales per new recruit has remained constant at $2,079 in 2012 v. $2,059 in 2008.
  • Net Sales per Churnout has also remained constant ex-2011 at $2,564 in 2012 v. $2,526 in 2008.

Q. How does this data overlay with Herbalife's Marketing Plan?

A distributor at the lowest level of the scheme must acquire:

  • 500 VP to earn 35% off
  • 1,000 VP to earn 42% off in a single month
  • 2,500 VP to earn 42% off for the year
  • 4,000 VP to earn 50% off for the year.

Each $1 is roughly 1.4 Volume Points. Curiously, the average Net Sales data per new distributor works out to just enough Volume Points to acquire a 42% discount with designs upon Supervisor status and a 50% discount.

Is that a mere coincidence? Or is it evidence that those who are signing-up as distributors might actually be chasing the "business opportunity"?

Whatever inference you draw on this point, the data doesn't lie. The data analysis confirms that Herbalife is a business that is dependent upon an endless chain of new recruits in order to sustain itself. The data analysis confirms that the good ship Herbalife grows almost exclusively by penetrating new markets to acquire greenfield distributors. There is no leverage in the model, no evidence of customer loyalty, no evidence of the 80/20 rule, no multiplier effect whatsoever.

Herbalife grows because new distributors recruited is > then those who churn out. Herbalife shrinks if new recruits are less than those who churn out.

Why?

Because there is no evidence of any long-run value in the business. Each distributor has a LifeTime Value of 2 years or less.

A pyramid scheme is a business that relies upon the endless recruitment of new participants in order to finance the economics of the compensation system. The scheme is destined to fail because the pool of potential recruits is not infinite, therefore those who sign-up at the end of the chain are destined to be disappointed.

Mr. Icahn seems to be focused on the historical growth of the company without, perhaps, contemplating whether or not that growth is sustainable.

However, common sense tells us that:

  • Herbalife's entire business model is dependent upon recruitment/finding new markets
  • New entrants/Jr. distributors are destined to be disappointed due to market saturation
  • Notwithstanding this reality, Herbalife imposes no geographic nor territorial restriction on its recruiting efforts.
  • Quite the opposite, the company relentlessly recruits new participants without regard for whether or not a "business opportunity" exists for the marginal entrant at all.
  • The company's growth is a function of its ability to globetrot and penetrate new geographies not customer retention.
  • Customers who actually use the product use it and leave in less than a year (even the company tells us this)
  • This makes it requisite (not just preferable but requisite) for the company to find new recruits each and every year it operates.

Why?

Because the productivity data reveals clearly that the company is an endless chain. Herbalife and its distributors use misleading statements to perpetuate the chain. The company recruits at any and all costs. The dream is a nightmare for most.

Why?

Because it is obvious to anyone who reads the Herbalife 10k that the entire business model for those in the upline is 100% dependent upon recruitment for its success and it is this dependence upon recruitment that makes it a pyramid scheme.

Longs point to growth data and free cashflow and evidence of customers etc. as support for the view that Herbalife is not a pyramid scheme when the obvious data point that trumps all of that evidence is the company's churn rate.

The relevant question is not: "Does the company grow?" but rather "How does the company grow?"

The answer, of course, is relentless recruitment.

De facto, the hyper-competition for new recruits by existing distributors bleeds all economic value out of the retail marketplace. Product gets discounted well below SRP, end-markets get over-saturated with "salespeople". The terminal result is baked in the cake. The last guy in has to lose.

This is the consequence of a scheme that refuses to limit its own proliferation and, in practice, actually encourages its relentless and aggressive expansion.

Herbalife is a pyramid scheme because it does absolutely nothing to protect its most junior recruits from economic loss. In practice, the company's policies guarantee their failure because it is always recruiting ad nauseum.

This is the only reason so many distributors might actually be "discount customers", this is the reason so many distributors discount the price of the product below SRP, this is the reason the recruiters mislead new participants with grandiose statements - because the end markets for Herbalife's business opportunity are obviously becoming saturated - which is why so many participants recruit customers as distributors because there is no retail market at full SRP once a geography is saturated.

Carl Icahn has acquired 14% of a company with a completely unsustainable business model. An endless chain. A pyramid scheme!

Why?

Because the nature of the compensation system and its limitless expansion guarantees that those at the bottom will lose.

Herbalife is a pyramid scheme because the company's business model depends upon endless recruitment for its sustenance.

The data is all right there in the 10ks and the company's Regional Metrics disclosures.

No Customer Loyalty + Endless Recruitment = Endless Chain

Endless Chain = Pyramid Scheme

No business that turns over close to 100% of itself is sustainable over time. The failure of the business is inevitable. Yes, the world is a big pond to fish in but it is not an endless one. And that is why this company appears to be a fraud, because its compensation system combined with its churn rate is set-up to saturate geographies and victimize the last guy in.

If it were not, distributors would be granted territorial exclusivity and not subjected to terminal intra-distributor hyper-competition.

Nothing Mr. Icahn says trumps that common sense argument, which is why the FTC and SEC should intervene.

Reductio Ad Absurdum: If Herbalife is not a pyramid scheme the business would be fine if it stopped recruiting. Yes?

Would we not see X = NS/NR increase over time?

Instead, Herbalife is obviously an endless chain -- a company that falls flat on its face if it cannot find new recruits.

Longs who ignore this do so at their own risk -- including Mr. Icahn.

Source: Herbalife Is An Endless Chain