Herbalife (NYSE:HLF) is a business. The question before the house is: "Is it a legitimate business?"
Pershing Square alleges that Herbalife is a merchant not only of Formula 1 Shake Mix but also the merchant of a business opportunity that promises wealth and prosperity but results in financial loss for those newcomers who take the risk to pursue the business opportunity.
If Herbalife is a fraud then it is one doozy of a fraud. The cashflows produced by the business have been aggregated, have been securitized, have been issued to the public and then traded publicly in the secondary markets where they have become the fish food of various hedge fund managers like Loeb, Soros, Ackman and Icahn and Chapman (guppy). Today's market cap is in excess of $6 billion. This capitalization would make Herbalife a fraud of epic proportions.
All of this public activity gives Herbalife the face of legitimacy. After all, how could a publicly traded company possibly be engaged in fraudulent activity? (Tyco, Enron, Bre-X Minerals, etc. aside)
However, the question of whether or not Herbalife is engaged in business opportunity fraud is not tied to the fact that its CEO used to be an executive at Disney Corp. or its product is actually consumed by end users or to whether or not the company is profitable or to whether or not the company trades at an 8 multiple or a 10 multiple or a 12 multiple or to whether or not the company has been around for 30 years or to whether or not the company is loved by its advocates, or to whether or not Mr. Icahn or even Mr. Ackman are talking their books.
Rather, the question of whether or not Herbalife is a legitimate business seems to boil down to the answer to this question:
"Does Herbalife as a company and its distributors as agents of the company advertise and promote a business opportunity that will lead to financial losses for those who sign-up to pursue the business opportunity?"
Put another way, are financial losses "baked in the cake" for new investors in the scheme?
To answer this question all I have to do is pretend that I am a new distributor. I can easily sign-up, get a business pack and order my first slug of inventory from the company. As a junior distributor I would pay 75 cents on the dollar for my inventory plus shipping and handling. If I want to buy my way to Supervisor/Inventory load I can do that too. Upline participants love Inventory Loading!
I would then have three notional ways to make money:
1) By selling the product at a mark-up to my wholesale price thereby earning a positive gross margin on every sale I make or
2) By recruiting other participants to buy and sell the product from me thereby earning a commission on every unit of inventory purchased by one of my recruits.
3) By convincing new recruits to buy inventory with high hopes and false promises.
These are the only three ways I can make money. These are the only three ways I can make a return on my invested capital that would include working capital in the form of inventory and human capital in the form of my time plus any additional marketing expenses I might incur.
Q. What does Herbalife know right now?
- Herbalife knows that distributors at the Supervisor level buy product at a 50% discount to SRP.
- Herbalife knows that these distributors routinely sell this product in the end market at prices well below 25% off SRP
- Herbalife knows that anyone who buys product from the company as a Junior distributor can only get 25% off SRP
- Herbalife knows that these junior distributors must compete with Supervisors for end-users/end customers at a market clearing price at retail that is below their COGS.
- Herbalife knows that if a Supervisor sells a can of shake for 25% off SRP they will make a contribution margin whereas if a Junior distributor sells the product at the same price then this distributor will lose money as they will have no contribution margin.
The implications of this thread of facts is simple. Any Junior distributor who tries to sell product at the prevailing market clearing price for Formula 1 product (25% off SRP or more) cannot make any retail profits whatsoever.
Ergo: There is no "business opportunity" as a retailer if you exist at the most junior levels of the Herbalife pyramid.
By simple process of elimination this leaves recruiting as the only alternative way to make some money.
Q. What about recruiting?
If a junior distributor cannot make money as a retailer, what is the likelihood that a distributor downline of a junior distributor can make money as a retailer?
The answer of course is obvious. The answer is 0%. If there are no retail profits to be had as a junior member in the Herbalife pyramid then anyone in the downline would be equally victimized by their inability to acquire product at a competitive wholesale price. By competitive I mean the price enjoyed by those who have reached the Supervisor level, namely 50% off.
Unquestionably, there is a significant volume of business activity occurring below the Supervisor level at Herbalife. This business activity includes:
- Inventory Loading
- Buying One's Discount
- Buying for Personal Consumption
- Buying to Advance in the Scheme
- Buying in the Hopes of Reselling the Product at a Profit
All of these reasons may be good faith reasons to invest in the Herbalife dream up front. The reality, however, is that those who buy HLF product because they think there is a legitimate "business opportunity" must discover that their dreams can only quickly become a nightmare. 90% churn out in less than a year.
Because there is a structural flaw in the Herbalife business model that discriminates against those at the bottom of the food chain in order to transfer economic value to participants in the upline. This is the structural flaw in the incentive system that may lead to the victimization of unwitting junior recruits.
Imagine if you will the most iconic of businesses in America today. Imagine a Lemonade Stand. Kids all over America cut their teeth as entrepreneurs setting-up lemonade stands. The first lesson that they learn is:
If you want to make any profit you must be able to find customers who are willing and able to buy your product at a price point greater than your Cost of Goods Sold. This becomes rapidly impossible if the incumbent kid around the corner can:
a) Buy lemonade crystals at a lower price than you and
b) The lemonade you are selling v. the kid around the corner is exactly the same (a perfect substitute) and
c) Both you and the kid around the corner are equally effective at "soft-selling", customer service, handholding, etc.
In practice, with such an ample supply of capable lemonade merchants customer service value gets bid out of the marketplace perhaps.
This leaves the market share spoils to the kid with the lowest price. True, friends and family may buy your opening inventory but after that the lemonade business becomes a dog eat dog world.
The only way you even stand a fighting chance is to get to "LEMONADE SUPERVISOR."
New Herbalife distributors who enter mature/saturated markets are getting scammed. They are told that they can make money as resellers and/or recruiters of those who will resell Herbalife product. In practice, there is no business opportunity to pursue.
Those who participate in the business model at the Supervisor level and higher have bid out all of the profits in the economy/marketplace. In practice, not only have margins been bid away but the Herbalife compensation scheme actually incents participants to amplify the true nature of the business opportunity with overzealous claims and promises of great wealth. Because upline distributors are paid on purchases and not sales to end users, the only incentive that upline participants have is to find enough recruits who are willing to buy an opening level of inventory so they can earn a commission. What happens to the product after that is of little to no concern for the upline player.
Herbalife has shifted gears now. They now argue that most of the Junior participants in the scheme are not distributors at all. Rather, they are "members" who are just signing-up to acquire the product at a discount. If that is true then this would serve as additional evidence that HLF's SRP is a total and complete fiction and that "Distributor Allowances" are a misleading data point. At best, the actual retail price that HLF product trades at is 25% off or less plus shipping and handling.
How does a Junior distributor find profits if the consumer next door is buying direct at 25% off?
What this means, of course, is that HLF must, therefore, be peddling a business opportunity that cannot and does not exist unless you are a Supervisor. The logic simply cannot cut both ways.
Either the junior members in the scheme are end-users which means there is no retail profit to be had unless you are buying product for 50% off or Herbalife and its distributors are knowingly selling newcomers a "business opportunity" that cannot exist.
Remember - Herbalife is not just a peddler of Formula 1 shakes. They are a peddler of distributorships. They peddle businesses. Specifically, they peddle a business opportunity.
Is this opportunity legitimate or not?
Does it exist or not?
If I sign-up to be a reseller can I make money or not?
Herbalife tells me yes. Basic economic analysis and common sense tells me that the answer has to be "No."
This, effectively, makes the drug Herbalife is selling a placebo, the promise of wealth and prosperity empty, and the dream a nightmare for most if not all junior recruits.
If you signed-up to sell Herbalife products today, could you make money? What does your analysis tell you?
Could you recruit additional people who could also make money?
What are the odds?
In the face of the grim truth, wouldn't the true economics of the actual business opportunity encourage you to stretch the truth to get a new recruit?
There are lots of businesses in the world that produce significant amounts of economic activity. Herbalife's economic activity is built upon a simple idea/life-cycle.
- Find a new recruit
- Get them to buy inventory/produce cashflow
- Transfer the cashflow/value from inventory purchases upline all the way to the shareholder.
- Leave the Junior Recruit holding the bag.
- Wash, Rinse, Repeat
550,000 new recruits signed-up this past quarter. Over 700,000 figured out the truth about Herbalife and left the company.
Any common sense analysis reveals that there is no free cashflow to be earned by the most junior participants in the scheme. There is no return on capital to be made. As a result, there can be no "business opportunity" for these participants which must make what Herbalife sells and promises hollow and fictitious.
The fact that Herbalife is able to continually source new recruits doesn't make it any more legitimate as a business. All this data proves is that Herbalife is successful at recruiting. Bernie Madoff was successful at recruiting. So, too, was Alan Stanford. Many sophisticated investors also bought sub-prime CDOs based upon what they were told by their recruiters.
The promise of great returns will always find a gentle ear if whispered softly enough.
Is Herbalife a Fraud? That is the Question
More specifically, is the company's marketing plan a form of business opportunity fraud aka a pyramid scheme?
If there is no retail spread to be earned at the bottom of the ladder, how can it be argued that this is a legitimate business? Doesn't it become obvious by process of elimination that the only residual economic profits can therefore only be earned by way of recruiting efforts - recruiting efforts that can only thus rely upon the misrepresentations of the "business opportunity"?
All of this logic reads like a circular reference to me. I wonder if regulators will agree.
Disclosure: I am short HLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.