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In an article I wrote earlier this year titled Herbalife is an Endless Chain I attempted to prove mathematically that Herbalife is a recruiting company and not a successful consumer products company that sells product to loyal customers who become repeat purchasers of the brand.

In this article, I would like to share some charts that demonstrate:

a) how Herbalife (NYSE:HLF) relies upon recruitment to grow

b) how evidence of saturation in mature markets is obvious

c) why Herbalife grows due to geographic expansion and not consumer loyalty

d) how Herbalife sales volumes curiously align directly with the "pay to play" incentives found at the bottom of the pay plan.

To begin, the source for the data I am about to present is the company's Regional Key Metrics disclosures from 2008 until the end of Q3 2013. This data can be found at ir.herbalife.com or with a simple Google search.

Recall, Herbalife basically has two broad classes of distributors.

Group A are the Sales Leaders. These are the company's recruiters.

Group B are the Non-Sales Leaders. These are the company's new recruits.

We are told that most of these people have no aspirations to become a Sales leader. Of course, if that were the case then none of the Sales Leaders who leave every year would ever be replaced.

The position of shorts like me is that many new Members immediately try to strive to qualify for SUPERVISOR status because that is what the pay plan's incentive system is designed to do. Herbalife tries to convince us that they are merely "personal consumers" who sign-up to get a 25% discount on product then quit within a year.

Q. How many new members do Sales Leaders recruit on average each quarter?


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Since the financial crisis in 2008 the quarter by quarter data is fairly consistent albeit with a modest uptrend. The average # of new Members recruited by each recruiter per quarter is roughly 1 person. On an annual basis this averages out to roughly 4 people per recruiter.

Q. What is the trend for Sales per Sales Leader?


(Click to enlarge)

Again, dating back to 2008 quarterly sales per Sales Leader is roughly $1,500 to $2,000.

Q. How does this compare to sales per New Member?


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Quarterly Sales Per New Member also trends consistently around the $2,000 level. This data point implies that new Members immediately inventory load when they sign-up.

Herbalife has expanded its geographic footprint from 65 countries in 2008 to 88 countries in 2013. However, its quarterly sales data per new member and per Sales Leader remains a largely linear function. This data tells investors that Herbalife grows due to recruitment and rapid geographic expansion and not customer loyalty.

Q. Considering the firm's reliance on recruiting, do we see evidence of saturation anywhere in the world?

The chart below shows the number of quarterly recruits per Sales Leader by geography for the past 3 years.


(Click to enlarge)

Herbalife appears to show positive growth momentum in South and Central America as each Sales Leader seems to be able to find in excess of 1 New Member per quarter on average. Meanwhile, in Mexico and North America the trend line is negative. Specifically, in Mexico it seems Sales Leaders are finding it harder and harder to find new recruits each and every quarter.

New recruits per Sales Leader in Mexico has fallen from .80 3 years ago to less than .6 in the most recent quarter.

The above chart reveals where and why Herbalife is growing in geographic detail.

As we shorts have argued many times before, we do not think it is a coincidence at all that:

a) Sales Leaders are only able to find an average of around 1 new member per quarter and

b) That the average amount of product purchased matches perfectly with the profile one would expect from a Member striving to become a Supervisor.

Recall, it takes about $3,000 worth of product purchases to become a Supervisor. In any given year, 50% of Supervisors are failing and churning out of the business. These folks who are failing are being replaced by new recruits who are aggressively pursuing Supervisor status as new "business opportunity" seekers.

Herbalife's argument that anyone who is currently not a Sales Leader is just a "personal consumer" or simply a Member is not only insulting to the intelligence of anyone with basic analytical skills. It is also clearly a misleading and opaque statement designed to confuse. Put simply, if none of Herbalife's Members were striving to become Sales Leaders the company would fall flat on its face within a year.

So, how does Herbalife grow? Herbalife tells a story about how Herbalife grows because there are so many retail customers out there who simply fall over one another clamoring for the cure to global obesity.

Alternatively, one could accept the view that most product purchases are the result of aspiring Supervisors chasing the dream $2,000 to $3,000 at a time. What does the data tell you?

No matter how you slice it, one thing is true for certain. Herbalife not only relies upon recruiting new participants to grow, it depends upon it. Herbalife has expanded from 65 countries to 88 countries. Recently they announced exciting plans to expand into Cambodia.

Q. Are they in the 3rd inning or 8th inning of their globetrotting ways?

Longs argue that the world is a big place. Longs argue that if Herbalife were a pyramid scheme we would see evidence of saturation already.

As we look at Herbalife's flat sequential QoQ results and weak guide for Q4 and 2014 plus the worrisome recruiting trends in Mexico and North America, is it far-fetched to conclude that Herbalife has already saturated certain markets?

You be the judge.

Investors need to understand how Herbalife grows to understand its business model.

Ostensibly, it sounds impressive that Herbalife has 3.6 million distributors and over 600,000 Sales Leaders. It sounds impressive that 70% of distributors are just Members buying product to lose weight. However, when you reduce the ratio of Sales Leaders to Members to a granular result you find out very quickly that the average Sales Leader is lucky to recruit just one new Member every quarter and no more than 4-5 per annum. As to the whereabouts of all the millions and millions of "ultimate users" outside the pay plan, your guess is as good as mine as to where they all live.

Is it any wonder why so many distributors fail at the business opportunity when you consider this limited opportunity set?

If Herbalife were simply selling shake mix to obese people for $30 per month, one would expect each distributor to have a meaningful number of people in their down line.

If, alternatively, we imagine Sales Leaders hunting for aspiring Supervisors instead of obese retail customers, it becomes easy to see how difficult recruiting becomes on a per Sales Leader basis.

Herbalife has recruited 5.2 million new Members since the beginning of 2011. This number climbs to 8.8 million people since the beginning of 2008. This result has been accomplished by a pay plan that encourages relentless recruitment to replace the participants who churn out in a year or two at most.

At $2,000 per member this equates to $17 billion plus of historical revenues. Will the future offer the same rich bounty? Will Herbalife similarly find another 9 million new recruits between now and 2018?

Q. If you were a banker, would you lend $2 billion to this kind of company with this kind of business model?

Q. If you were a long-term investor, would you assign a premium P/E ratio to this company's cashflow stream?

What does common sense tell you?

Next time you hear an Herbalife executive or Tim Ramey speak on TV make sure to watch his nose to see if it grows as the nose might grow like Pinocchio's.

Herbalife is a global pyramid scheme. The sooner the SEC shuts it down the better.

Source: Herbalife Grows Like Pinocchio's Nose