We have published a series of articles on Herbalife (HFL) (see links 1, 2, 3 and 4) recently outlining the fundamental flaw in Bill Ackman and his team's understanding of a pyramid scheme. Our earlier work contained detailed concepts and quantitative calculations showing errors in Ackman's argument. However, for those who will like to have a better feel (from the business perspective) of the absurdity of Bill Ackman's arguments and his interpretation of a pyramid scheme, we present here a qualitative discussion of the same. In addition, we are pointing out some additional flaws in Ackman's presentation to help the investment community get a better understanding of the mistakes in Pershing's analysis.
This article consists of three parts:
- First, I have expressed the problem with Ackman's pyramid allegation with a simple example.
- Second, I have discussed whether Pershing Square has got the value proposition of Herbalife products right and if Herbalife products are really overpriced.
- Third, I have addressed short sellers' myth that Herbalife's high gross margin means that it is overpricing its products and discussed how to compare Herbalife's Gross Margin with a non MLM company on an apple to apple basis.
Problem with the Pyramid Scheme Allegation
To start with, let's think of a MLM company which produces goods for $50 mn, sells them to its distributors at $200 mn, who in turn sells them to their retail clients at $250 mn. Out of the Gross Profit of $150 mn generated from the sales, the company pays an amount x to distributors as Royalty Overrides.
Now, according to Ackman's representation, the company is a legal MLM organization if x < $50 mn and a pyramid scheme if x > $50 mn. So, if the company is paying $40 million out of its gross profits as royalty overrides, Ackman won't question it. On the other hand, if the company becomes more benevolent and decides to pay $60 million out of its Gross Profits so that its distributors can make more money, it becomes an illegal pyramid scheme and Ackman would like the FTC to shut it down.
This clearly is ridiculous and equally baffling is the fact that Ackman wants to use this argument to persuade the FTC to take action against Herbalife. It shows Ackman's lack of basic understanding of the MLM business.
Now, why did Ackman made this mistake? Because neither he nor his Herbalife analyst Shane Dineen cared to read Peter Vander Nat's paper on differentiating between a MLM and a pyramid scheme properly. If they didn't even cared to read a simple 13 page paper which they have cited four times in their presentation and recent (February 7th) questionnaire to Herbalife, what else can you expect from them?
Are Herbalife's Products Really Overpriced?
Pyramid allegations aren't the only place Ackman erred because of the lack of proper work and analysis. Same thing happened when he talked about Herbalife's products being overpriced. When Pershing's team did channel checks in Herbalife's nutrition clubs, they could have stayed there for a day and got a better understanding of consumer buying behavior. Instead they ended up mocking the localities these places are in, plastic chairs in them and the ambiance. No wonder they ended comparing the product offering in nutrition clubs with those available on Walmart.com.
When an obese person sees the banner "Loose Weight Now, Ask Me How," it is not just a weight loss powder he/she is looking for. It's the support system, a hope that there is some one out there who can help him/her achieve his/her goal of a healthy lifestyle. That's where the pricing premium comes in. This was not a very difficult thing to figure out if Ackman's team would have done the channel checks in nutrition clubs properly. Nutrition clubs are the places at the relatively higher end of the pricing spectrum and analyzing the value they offer to consumers could have been an eye opener for Ackman. But Ackman's overzealous analyst chose to present to him what he wanted to see, and Ackman believed him.
Herbalife's nutrition clubs are a key driver of the company's growth and the company has made opening them really easy. Distributors can open these clubs even at their residence. It's really surprising that Ackman chose to criticize this aspect of Herbalife's business.
What About Herbalife's High Gross Margins?
Another argument which Ackman used to suggest that Herbalife's products are overpriced was by comparing its gross margins (~80%) to the other consumer companies (~ 45%). However, he didn't made an apple to apple comparison and again misled the investment community. To do a proper comparison and put an MLM company's gross margins in perspective with respect to its non-MLM counterpart, let us first understand the difference between income statements of the two.
A non-MLM consumer company's P&L ends where its distributors/retailers P&L start. For a MLM company there is an overlap between the two.
Non MLM Company
Multilevel Marketing Company
If a product X is sold by a non-MLM company and a MLM company, and distributors/retailers make same amount of money selling product X at the same price to retail clients, gross margin of MLM Company will appear artificially inflated. This is because the net sales number for the MLM Company will contain Royalty overrides (a part of distributor's P&L in case of normal company) which will reduce COGS as a percentage of net sales. So, to do apple to apple comparisons, one needs to subtract royalty overrides while calculating the adjusted margins.
Let's calculate gross margins of HLF for the year 2011, after adjusting for the above:
Product Sales = $2,945 million
Cost of Sales = $680 million
Royalty Overrides = $1,138 million
Recruiting Rewards in S,G&A = $291 million (according to Pershing's estimates)
Product Sales after adjusting for Royalty Overrides and Recruiting Rewards in S,G&A for doing apple to apple comparison = $1,516
Gross Margins (adjusted for it being an MLM company) = 55% (approx.)
Actually, the real figure will be closer to 60%. We have excluded shipping and handling completely in the above calculation. In reality, a part of it will go to MLM's Net Sales while adjusting for differences in its distribution structure versus its non MLM counterpart.
But does a 60% gross margin (adjusted), which is on the higher side of other consumer companies, make Herbalife a pyramid scheme? By that logic Proctor & Gamble (PG), which is Pershing's second largest holding, is a pyramid scheme because, in the last quarter, it reported Gross Margin of 51% unlike Clorox's (CLX) 42% margins.
Proctor and Gamble
The Clorox Company
Cost of Goods Sold
For the three months ended December 31, 2012
Worse still, since Proctor & Gamble is in the middle of a restructuring/cost cutting process which will increase it gross margin; it will become closer to a pyramid scheme as it succeeds, according to Ackman's argument. No wonder why Proctor & Gamble is not giving much heed to Ackman's activist suggestions despite of his large stake in the company.
What Next ...
There are more errors in Ackman's work and we will continue to bring them to Bill Ackman's, Shane Dineen's and Pershing's notice in our future articles. Our aim is to help them better understand the flaws in their arguments.
It appears that Ackman and his team are quick learners. What are the indications?
- The usually chatty Ackman is not returning phone call from journalists.
- When, in mid February, Carl Icahn announced his Herbalife stake, Ackman offered a quick rebuttal that he has done his work properly. This time he was silent.
- He said he will be shouting from the roof top to make sure FTC takes action against Herbalife. We don't hear any shouts no more.
- It's perhaps my overconfidence speaking but I think the factsaboutherbalife website will stop updating now. He won't take it down till he is done covering, but he won't be updating it.
While Ackman continues to realize his mistake, the broader Wall Street still suffers from the "fool poisoning" he has spread. The other day, I was shocked to see Jim Chanos talking about Herbalife's overpriced products. Clearly, he must have assumed that Ackman has done his work properly and didn't cross checked. In addition to Bill Ackman and his team, we hope our work will also help broader Wall Street realize that Ackman's thesis is broken now and you won't find him shouting from the roof top anymore.
Links to our previous articles on Herbalife:
- Herbalife: What Exactly Is In Peter Vander Nat's Paper And Why Bill Ackman Is Wrong
- Reply To Bill Ackman's Questions On My Herbalife Analysis (Part 1)
- Reply To Bill Ackman's Questions On My Herbalife Analysis (Part 2)
- Herbalife: Here's Why You Won't Hear Ackman's Defense This Time
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.