Today is January 2. Tim Ramey just made Herbalife a "Best Idea" for 2014. January is the month that many Herbalife distributors will "pay to play" to requalify for Supervisor status. Many others will be demoted and churn out of the pyramid for good.
Before Christmas, Herbalife (NYSE:HLF) released its public audit. In the updated 10-Ks, the company reveals what percent of Net Sales comes from actual product sales and what percent of net sales comes from Shipping and Handling revenues. What Herbalife does not disclose, however is the costs of their Shipping and Handling program.
In April of 2011, this fact struck the SEC as a curious dynamic so the SEC sent Herbalife a letter, which can be found here.
Herbalife responded to the SEC's letter with a letter of its own that can be found here. Here are the highlights of the company's response.
We note the Staff's comment, and in response thereto, respectfully advise the Staff that in Note 2, Basis of Presentation, under the heading of "Revenue Recognition," in the notes to consolidated financial statements on page 104 of the 2010 10-K, we disclose that shipping and handling costs paid by the Company are included in cost of sales. The shipping and handling costs for 2010, 2009 and 2008 were $58 million, $49 million and $48 million, respectively.
Both Pershing Square and Shortzilla seized on this data point and immediately recognized that Herbalife's Shipping and Handling program is a huge profit center for the company.
Let's step back to the 10,000 foot level for a moment. The first time I looked at Herbalife's financials, what struck me was how usurious their operating results are. Here are the company's ratios from 2012.
Herbalife Income Statement Ratios 2012
Income Before Taxes
Herbalife prints 80% gross profit margins, 16% operating margins and 11% net margins.
Q. How does Herbalife do it?
By now investors are aware that Pershing Square believes that the reason Herbalife realizes such super-normal profits is because it is a recruiting scheme commonly known as a pyramid scheme. A pyramid scheme is a money transfer scheme. Profits are transferred from victims at the bottom of the scheme to those at the top. Looking at the results for shareholders, it is obvious that owners of HLF common are making out like bandits. Meanwhile, over 6.5 million distributors have been torched by the Herbalife scheme since the beginning of 2008. Also, a quick look at the company's Average Statement of Compensation reveals that very few distributors get paid any money by the parent company at all.
Money Transfer schemes like the game of Poker are zero-sum games. One person's winnings are another person's losses. Herbalife's business model is perverse because it relies upon the ongoing recruitment of new "losers" for its sustenance vs. creating value for all participants in the distribution chain.
It also occurs to those of us who are skeptics that Herbalife's Shipping and Handling program is a central component in its effort to extract value from its business partners known as distributors while further guaranteeing their inevitable economic loss.
Q. Why wouldn't Herbalife disclose the costs of its Shipping and Handling program for investors and distributors alike to see? According to Des Walsh, Herbalife is committed to transparency. Or Is "transparency" just an empty promise? You be the judge.
For fun, I took Herbalife's operating results from 2006 - 2012 and normalized them in the interests of full disclosure. Here are the results:
Shipping and Handling Revenues
Shipping and Handling Expenses
Shipping and Handling Profit
Impact on Operating Income
Total Operating Income
Shipping and Handling Profit
% to Total OI
* 2008, 2009, 2010 Shipping and Handling Actual taken from SEC Correspondence.
** 2006, 2007, 2011, 2012 estimated using Avg. S & H Ratio from 2008, 2009, 2010
When you back out Shipping and Handling from Net Sales and Gross Profit you discover a few key data points:
- Gross Profit on Product falls from above 80% to below 80%
- Herbalife makes 85% Gross Profit Margin on its Shipping and Handling Program
- Most of Herbalife's Operating Income gets wiped out if S&H ceases to be a profit centre.
To me, this analysis begs the following question:
If Herbalife distributors are now aware that the company made $500 million in profits from Shipping and Handling in 2012, might they seek to cut a new deal with the parent company?
If you were a distributor and you knew that Herbalife was marking-up your shipping costs 85%, wouldn't you be a tad irate?
Famous Harvard Business School Economist Michael Porter wrote about the 5 forces a firm has to deal with as a competitor. Here is a picture of Mr. Porter's model. Bargaining power of buyers is one of the 5 forces and can also be a very powerful one.
Q. In the relationship between Herbalife and its network of distributors, who holds the balance of power going forward?
I can't say for sure, but it certainly seems pretty obvious to me that Herbalife is trying to hide from its salespeople how much money it makes when they pay for shipping. How long these margins last is anyone's guess.
Usurious Shipping and Handling fees impact distributors and customers in a number of ways.
- The profit pool is captured by the parent company instead of the distributor.
- The higher fees must be passed on to the consumer or absorbed as an added expense by distributors.
- Customers must end-up paying a higher price for Formula 1 in the end-market for retail margins to remain intact.
Market evidence suggests that while the parent company is making out like bandits on Shipping and Handling fees and most product seems to be sold at a retail price of 25% off SRP or more, it is the poor distributors in the middle who, yet again, eat the economic loss resulting from this extraordinary surcharge.
This leads to them failing at the business opportunity and churning out of the pyramid. Most do so in less than a year.
Of course, Herbalife's Shipping and Handling program also has material implications for Section 5 of the FTC Act too. (This the part that regulates deceptive marketing practices.)
- How can it be possible for distributors to earn up to 73% profit if they have to eat S&H fees?
- How can it be possible for a junior Member to make profits as a retailer if COGS is pushed higher than a Sales Leader due to S&H fees?
- Is there a retail business opportunity at all if you are not a SUPERVISOR?
I am confident by now that regulators understand the absurdity of many of Herbalife's promises to its potential recruits.
What is more interesting to me, however, is the answer to the following questions:
How much longer will the 3.6 million independent distributors allow the parent company to bully them with an obviously outrageous pricing scheme for S&H?
Might a revolt on the Shipping and Handling front lead to a change in Herbalife's profit margins going forward?
Mr. Ramey thinks investing in the good ship Herbalife is a "best idea" for 2014.
My "best idea" is that regulators should shut down this rigged game as soon as it can assemble the evidence for a court filing.
Each and every day this company is allowed to operate it confiscates the hard-earned savings and dignity from unsuspecting victims with a rigged game and sordid compensation scheme.
Grotesque and undisclosed Shipping and Handling profits are just another example of how the deception functions at a granular level.
How anyone can make a retail profit buying product for 85 cents on the dollar when it is being sold in the end-market for 60-70 cents on the dollar escapes me completely.
Apparently, it also escapes the millions of distributors who have resigned from the Herbalife confidence game over the past 5 years alone too.
Happy New Year
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.