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Herbalife (NYSE:HLF) investors may not have noticed but the SEC published an updated Pyramid Scheme alert today via their website and Twitter (NYSE:TWTR) account. The timing of this alert coincided with the dismissal of Herbalife's Motion to Dismiss in the Bostick v. Herbalife class action lawsuit.

Cross-checking these two documents one thing becomes obvious. Participants in a pyramid scheme are not considered "ultimate users" so its back to the drawing board for Herbalife's attorneys.

A legitimate MLM is designed to promote and encourage retail sales to people who are not participants in the MLM. A pyramid scheme sells product primarily to members of its distribution network. The purchases of the junior members of the network finance the profits of the senior members of the network.

If the junior members of the network fail to make money, one would expect a very high turnover/failure rate among junior participants (for HLF it is > 90% per annum). The sustainability of the scheme is driven by the ability of the senior members of the pyramid to continue to recruit and source junior members. This process continues ad infinitum until it inevitably runs out of runway/opportunity set.

If the majority of the economic activity that occurs in the junior ranks occurs because these new recruits are trying to qualify as SUPERVISORS/advance in the scheme then these purchases are unrelated to retail sales. If commissions paid are paid based upon product purchased and not product sold to non-participants this is also a key indicator that a company may be a pyramid scheme according to the SEC.

In this article I would like to revisit one of the arguments tabled by HLF to avoid pyramid scheme prosecution. Herbalife argues that 73% of its distributors have no downline and purchase product primarily for personal consumption to receive a discount. Next earnings release we are told that these junior distributors will be called "members" as part of a new nomenclature initiative.

Let's think about the mechanics of that claim.

It is reasonable to conclude that Sales Leaders are recruiters. These are the folks that are constantly hunting and gathering new distributors. When a junior distributor signs-up with Herbalife the junior distributor goes into the Sales Leader's downline. The Sales Leader makes commission.

Presumably a big part of "the pitch" to these 73% of people who are not interested in the business opportunity has to be the performance of the product. "Hey, I can help you trim a few inches from your waistline. Interested?"

To sweeten the pot, supposedly HLF signs-up these people as distributors. This means that the only reason they sign-up is to get a discount on product. We are told that a discount of 25% of SRP is a meaningful enough incentive for these folks. Meaningful enough to get them to buy an IBP to secure a 25% off price.

But remember, they have no interest in the business opportunity. (wink wink)

Q. What do the results of this compelling offer yield at the end of the year? How many new distributors does each Sales Leader recruit?

The answer is an average of around 5. According to HLF's Annual Statement of Average Compensation Sales Leaders have an Average of around 5 junior distributors in their downline.

Stated another way, Herbalife's very best recruiters selling the very best attributes that F-1 shakes have to offer to "members" who are only interested in losing weight and nothing else and who are willing to pay $59 just to get 25% off the SRP are only able to find 5 people each on average to join as "members" of their downline.

According to Herbalife slightly less than 4 out of every 5 of these people have absolutely no interest in the business opportunity.

So, this got me thinking. If the only way to buy F-1 is through a distributor and the reason people sign-up to become distributors is just to get a discount, wouldn't it seem reasonable that everyone who has no interest in the business opportunity would sign- to become a distributor? Wouldn't every rational consumer want 25% off? Wouldn't that be the norm v. the exception?

Put another way, if what Herbalife says is true. If junior distributors are just discount buyers, why would we expect Herbalife to have any customers outside of its distribution network at all?

If you were looking to lose weight, wouldn't you want a discount too? Funny thing is, Herbalife tells us that it has millions and milions of customers who never sign-up to become distributors at all. Weird, don't you think?

How can it work both ways? Herbalife argued in the Bostick case that the State of California says its okay if distributors are considered "ultimate users". The Judge disagreed. So, now Herbalife finds itself in a bit of a pickle.

If the 73% of the "members" of the pyramid scheme don't count as "ultimate users" presumably the company will now have to produce evidence that the millions of people who are not signing-up to receive a 25% discount actually exist. What are the odds of that?

If the company's very best recruiters can only find an average of 5 super-charged, hopped-up customers so fired-up that they want to sign-up as distributors to get a discount, how many external customers do you think they are able to recruit?

Would you expect the number to be higher or lower? What does common sense tell you?

Let's be clear about the mechanics of Herbalife's existing compensation scheme. The tiered discounts/preferential pricing given to SUPERVISORS clearly incents new recruits to inventory load. It is this inventory loading that is likely the driver of purchases, commissions, revenues, cashflows, and ultimately churn.

As for all the people out there trying to get skinny? Unlikely they exist at all.

This week the California courts and the SEC delivered warning shots to long investors. If you are counting on the government accepting the idea that junior distributors are just customers think again.

If you are counting on the existence of millions of legitimate "retail customers" rethink that position too. For Herbalife to escape pyramid scheme prosecution they are going to have to pull two rabbits out of the hat.

1) They are going to have to require these so-called "discount customers" to sign some kind of contract that limits their participation in the scheme to consuming only/make them non-participants in a bright line way and,

2) They are going to have to eliminate the tiered pricing in the compensation system that currently leads to inventory loading by biz-opp seekers and therefore product purchases "facially unrelated to retail sales".

Legitimate, external consumer networks and flat wholesale pricing are two key features that are prevalent for legitimate MLMs like Nuskin (NYSE:NUS). Otherwise, the noose will continue to tighten.

Of course, if Herbalife actually makes these changes in all likelihood the effectiveness of the marketing plan starts to collapse. After all, how much inventory will people buy if there is no incentive to get to SUPERVISOR via a bigger discount?

How much recruiting will take place if Sales Leaders actually have to find real retail customers? And herein lies the rub.

Investors who continue to cling to the notion that junior distributors are discount customers beware. The law is not on your side. How do we know? Both the SEC and the California court system just told us so.

In the interim, Herbalife remains a pyramid scheme and a short sale at $65.

Caveat Emptor

P.S. Keep your eyes on the Churn Data when results are released next week. Will another 700,000 distributors resign?

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.

Source: Noose Starts To Tighten Around Herbalife's Neck