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Herbalife (NYSE:HLF) now wants us all to believe that its Junior distributors sign-up as distributors simply to buy product for personal consumption. The company seems to be having a tough time proving it makes retail sales and so its disclosures have changed quite a bit. Of late, based upon an ad hoc January 2013 survey of 408 ex-distributors conducted by Lieberman research.

The majority (73%) primarily joined us to receive a wholesale price on products they and their families enjoy.

Does this pass the smell test?

Let's look at what the company has said historically on this issue.

Prior to 2011 Herbalife had the following to say in its 10ks about its Distributor base.

We believe that the distributors who have not attained supervisor level can be segmented into three general categories based on their product order patterns: discount buyers, small retailers and potential supervisors.

We define discount buyers as customers who have signed up as distributors to enjoy a discount on their purchases; small retailers as product users and salespeople who generate modest sales to friends and family; and potential supervisors as distributors who are proactively developing a business with the intention of qualifying to become a supervisor.

In 2007, excluding China, distributor orders for these three general categories were approximately 52%, 26% and 22%, respectively. (48% retailers and recruiters)

In 2008, excluding China, distributor orders for these three general categories were approximately 51%, 29% and 20%, respectively. (49% retailers and recruiters)

In 2009, excluding China, distributor orders for these three general categories were approximately 47%, 36% and 17%, respectively. (53% retailers and recruiters)

In 2010, excluding China, distributor orders for these three general categories were approximately 29%, 57% and 14%, respectively. (71% retailers and recruiters)

Beginning in 2011 Herbalife stopped disclosing this data. Read the following exchange between David Einhorn and the company on the Q1 Conference Call.

(Q - David Einhorn): Okay. What is the incentive for supervisor to sign somebody up to become a distributor as opposed to - if they're just going to consume for themselves as opposed to just selling them the product for the markup. How does the distributor - how does the supervisor come out better?

(NYSE:A): Sure. So, I think there are two reasons for that. So, we know from our business today that many of our future supervisors and business builders come in as customers and then they become distributors. So, the benefit from a supervisor is the ability for greater retention of that customer/distributor because they are now earning a 25% discount. The second issue is that it preserves lineage. So obviously, if I sign you up David as a distributor, my hope and my expectation is that based on the tremendous product result that you're going to achieve that you'll have friends and families go to you and say, gosh David you look great, what do you want. You're going to respond to them, I'm on Herbalife, and that will encourage you to say, wow maybe this is a business opportunity I could be interested in. So, the benefit for me as your supervisor is one, the discount that you would get and that for my greater likelihood of retaining, it was a permanent customer and secondly, the hope that at some stage, you will decide to do the business and therefore that you are already in my lineage and is part of my group.

(Q - David Einhorn): Right. But just trying to understand this clearly, if I sell to a customer, I bought it - I'm a supervisor, I buy at a 50% discount, I sell to a customer, I make 50 points, if he pays the full price. If he signs up with a distributor and buys it himself, he gets a 25% discount and I get seven points as a royalty. Is that how it works?

: No, you would get the other 25%.

(Q - David Einhorn): I will get 20% plus the 7%.

: So, unless you're are on royalty you would simply are in the difference. So, you are in a 50% discount, you are selling at a 25% discount, and so the difference between the two is your profit on that sale.

(Q - David Einhorn): Right. So if he signs up with a distributor and buys it for himself from Herbalife, I still get the 25%.

: That is correct.

(Q - David Einhorn): Okay. Good. One last question, when you had your previous 10-K, you disclosed three groups of distributors at the low-end. You called 29% self consumers, 57% small retailers, and 14% potential sales leaders and then that disclosure did not repeat in the subsequent 10-K. So, I got two questions, first of all how do you track that and how do you characterize and know which ones are which? And second, why did you stop disclosing that in the last 10-K? Is that something that you stopped tracking or just stopped disclosing?

(A - John Desimone): David, Hi, this is John. The criteria for grouping distributors into different classes was based off of their volume purchases and we are making assumptions that people below of certain volume. While doing the business, they were buying soft consumption and I don't remember the exact amounts, but I can get it to you after the call, as how we delineated between the three classes.

And one the reason that we took out of the 10k is a change in CFO from which to me I didn't view it is valuable information to the business or to the investors. However, we can easily provide the exact same breakout going forward if you would like [indiscernible] into our investors. Again, I don't remember the exact delineation between the three classes, but I can certainly get it to you. Our objective is to be completely transparent, so.

(Q - David Einhorn): Thanks [indiscernible], I appreciate that sort of follow up, that will be helpful.

: Thanks.

(Q - David Einhorn): Thank you so much guys.

Following this exchange at the end of 2011 in the 10K the company wrote:

We segment the distributors who have not attained the sales leader level into three general categories based on their product order patterns: discount buyers, small retailers and potential sales leaders. We define discount buyers as customers who have signed up as distributors to receive a discount on their purchases; small retailers as product users and sales people who generate modest sales to friends and family; and distributors who are proactively developing a business with the intention of qualifying to become a sales leader.

No percentages were disclosed.

In 2012 the language changed again:

People become Herbalife distributors for a number of reasons. Some join simply to receive a wholesale price on products they and their families can enjoy. Some join to earn part-time money wanting to give direct sales a try, whereas others are drawn to Herbalife because they can be their own boss and can earn rewards based on their own skills and hard work.

Prior to 2011 between 48% and 61% of Herbalife distributors were considered retailers or recruiters.

In 2013, 73% are now miraculously considered "simply" personal consumers.

On the 2011 Q1 conference call with David Einhorn, Des Walsh stated clearly that distributors are recruited in the hopes that they end-up pursuing the business opportunity.

In the 2012 Statement of Average Compensation the company is now telling us that these individuals are now just customers who have no intention of pursuing the business opportunity.

My how the sands have shifted.

Let's be clear about a number of ideas.

Individuals sign-up as Herbalife distributors because they are recruited to do so by those in the upline. There is no requirement for a customer to sign-up as a distributor to receive a 25% discount. There is no requirement for a customer to pay Shipping and Handling. There is no requirement to buy an IBP. Product is ubiquitously available online for 25% off or more. Individual distributors at the Sales Leader level discount product all the time for retail customers.

The reason that an individual is signed-up as a distributor is to get them started on the road towards Supervisor, to indoctrinate them into the scheme. As Des Walsh clearly states in his answer to David Einhorn, individuals are recruited to preserve lineage and to encourage promotion of the "business opportunity". Any arguments to the contrary are nonsense.

Of late, the company has focused upon the motivation of the junior recruit as evidence that the participants have no intention of pursuing the business opportunity. At the same time, we know categorically from the company's own disclosures that all upline Sales Leaders are actively trying to recruit and develop individual participants to be part of the scheme.

Herbalife wants us to accept all of the distributors who have no downlines as evidence that retail sales exist. Rather, it seems quite obvious that all of these participants are merely evidence of a compensation system that rewards and encourages endless recruitment and compensates individuals accordingly.

Herbalife wants us to look only at the bottom layer of the scheme. When one broadens the outlook to include the motivation of Sales Leaders it is obvious that junior disributors are not simply personal consumers but are actively recruited to become part of the scheme itself. This is why the Koscot test requires retail sales to be made to ultimate users defined as individuals outside the compensation scheme.

Think about it rationally. If a customer came to you and said. "Hi, my name is Sue. I want to lose weight. I have no interest in ever selling the product. I have no interest in ever recruiting." What would you do?

Why would you make Sue pay $59 for an IBP and have her fill out a bunch of paperwork v. simply retail the product to her at a discount?

The answer is obvious. Upline participants in the Herbalife scheme are in the business development game. They want recruits, they want them consuming, they want them selling and they want them recruiting. Upline distributors will pursue any and all avenues available to them to get a downline participant to order product under their distributor code so that they get the Volume Points and commission associated with those purchases. The upline individual is completely indifferent as to where the product ends-up. As long as it gets purchased they get paid.

Obviously, once an individual is signed-on as a distributor the full force of the marketing plan is applied from above. Inventory loading is encouraged, personal consumption is encouraged, recruiting is encouraged and retailing is encouraged. Clearly the line between "retail sales" and the "business opportunity" is blurred.

Herbalife is trying to brightline its distributors with no downlines as just "retail sales". The company's own disclosures and common sense tell us that this kind of logic is nonsense. Anyone who is signed-up as a distributor is obviously part of the scheme, somewhere on the road to Supervisor.

New recruits in their first year end-up somewhere on the climb. Some make it all the way to Supervisor, some never reach the top, some barely start the climb at all. Most if not all quit within a year. Whether some only drink shakes or make small purchases to retail or try to recruit, the result is always the same. In less than a year they are gone.

Herbalife is always recruiting. Why? Because that is what its compensation scheme encourages participants to do. How else do you get 2 million new recruits in 2012? But make no mistake. It is an endless chain. It will run out of runway. The data makes this result inevitable. In the interim, the company wants us to believe that 73% of its distributors have no interest in the "business opportunity" even though as recently as 2010 it told us that over 70% were retailers or future Sales Leaders. Hmmm?

Think about it this way. If Herbalife's compensation system rewarded particpants based upon actual retail sales, why would anyone recruit somebody to be a distributor if they had no interest in the "business opportunity"?

The answer, of course, is you wouldn't unless the obvious motivation is to nurture the "business opportunity" too.

How do we know that all recruits are part of the scheme and not ultimate users outside of the scheme as articulated in the Koscot test?

Des Walsh told us in 2011 when he answered David Einhorn.

To be clear, the majority of Herbalife distributors are "simply" distributors, somewhere on the continuuum in pursuit of the "business opportunity". Most fail or resign in less than a year, most end-up being replaced by new recruits. The endless chain proliferates until, of course, it can't find anyone else to recruit. The sooner it is stopped, the better.

As for the personal consumption myth? 408 ex-distributors is hardly sufficient evidence to overcome an entire Marketing plan that encourages endless recruitment over retail sales.

Source: Shattering The Personal Consumption Myth 2.0