Herbalife (NYSE:HLF) is now the subject of an FTC investigation. The stock is under pressure again today. Over the past few trading sessions, Herbalife common has received a haircut in the order of $1.5 to $2 billion in market cap. Still, the stock is bid roughly $5 Billion. That is to say that market participants seem to expect the present value of the future cashflows they will receive as equity investors will equate to roughly $5 billion. If we anticipate roughly $650 million in free cashflow from Herbalife in the coming twelve months, the market is telling us that they expect Herbalife's business model to survive beyond this year. As an equity investor, this is not a bet I would make with my capital. Frankly, I remain surprised that Herbalife is not trading for $25 per share or less at the moment. Still, I suppose the fact that over 25% of the company's common sits in the hands of Mr. Icahn and Mr. Stiritz might provide some explanation as to why there is still a reasonable bid under the shares. How long that bid lasts is anyone's guess.
In the interim, the FTC has launched an investigation into Herbalife. Undoubtedly, the FTC will be applying the law as articulated in the Koscot v. Interplanetary case to the Herbalife pay plan. Recall, legitimate MLMs produce lots of retails sales to lots of customers who are not participants in the company's pay plan. Pyramid schemes are primarily closed economies that rely upon perpetual recruitment of new victims for their sustenance and are destined to fail because they are endless chains.
What we know about Herbalife is the following:
- the company does not track retail sales to ultimate users
- the company does not have a consumer network like Nu Skin (NYSE:NUS)
- the company does not enforce its 70% rule or 10 customer rule
- the company's testimony/disclosure on "The Retail Question" has changed materially over time.
- the company's wholesale pricing discriminates against its own distributors
Make no mistake if you are long, it is unlikely that Herbalife has many retail customers to "ultimate users" at all. The reason why is easy to understand. The reason why is obvious if you contemplate the Herbalife indoctrination process. You see, anyone and everyone who is a Herbalife distributor is conditioned to recruit. This company is a recruiting juggernaut. Supervisors and aspiring Supervisors are trained to build out their downlines, invite prospects to opportunity meetings and develop recruits into Supervisors. Anyone with a heartbeat and $59 to spare is immediately encouraged to sign-up as a distributor.
If you want to understand the reason why, I encourage you to listen to this audio exchange between Mr. David Einhorn and Herbalife President Des Walsh. David asks "The Retail Question" but then continues on with this additional inquiry:
"Why would a Supervisor sign somebody up as a distributor versus just sell the product to them directly?"
Mr. Walsh's response is instructive and gives us the reason why it is unlikely there are many "ultimate users" of Formula 1 at all.
Let's be clear. Herbalife's current position for market participants is that distributors join-up "primarily" to receive a discount on product for their personal consumption. The company goes on to say that for many distributors this is "the only reason" they sign up. According to the Annual Statement of Average Compensation the rough estimate is that 71% of distributors fit this description.
Make no mistake, the goalposts have moved on this data point. As recently as 3 years ago less than 50% of Herbalife distributors who were not yet Supervisors were considered personal consumers. The rest were considered small retailers or aspiring Sales Leaders based upon the volume of product they purchase. Today Herbalife wants us to believe that not only are these people "personal consumers" but that they also have no interest in the business opportunity simply because they have no downline - yet.
The trouble with this argument is that it is absurd. The reasons it is absurd are as follows.
The first reason is a question of simple mathematics. In order to qualify for a 25% discount on product a distributor must pay a $59 membership fee. $59/25% = $236. That is to say that any new customer would have to buy a minimum of $236 of product in order to begin to see the benefits of the discount - not exactly what one would expect from a "personal consumer" maybe? Plus, members must absorb all shipping and handling and sales tax surcharges too effectively offsetting much of the value of the membership fee. Perversely, discount seekers have more of an incentive to not sign-up as distributors than to sign-up and pay a fee to acquire a discount.
The answer (and second reason ) is a question of rational behavior. Lower prices for product are ubiquitously available online with free Shipping and Handling thrown in. Price seekers in search of a discount would rationally choose to acquire product from this kind of supply depot v. pay a premium through a distributor.
The third reason is a question of perspective. Herbalife constantly emphasizes the perspective of the junior recruit. Junior recruits join-up so that they can get a discount on product. Herbalife, of course, conveniently ignores the perspective of the recruiters. The recruiter's objective is altogether different. The recruiter's objective is to wine and dine and develop each and every new distributor into a productive recruiter themselves. The recruiter's goal is to get the new distributors to aspire to participate in the business opportunity. The recruiter's goal is to get the new distributors to purchase an opening level of inventory to resell. In no way shape or form is it the recruiter's objective to simply leave the new distributors as a "personal consumer". Personal consumption is simply the first stepping stone on the way to President's team. Nutrition Club's, Opportunity Meetings, Extravaganzas, etc. are all waiting in the wings for the new recruit. These recruiting activities are what Herbalife is all about. Herbalife trains its recruiters how to indoctrinate people into the Herbalife world. "Personal Consumers" are the fresh-faced marks destined to become the latest victims of the recruiting scheme.
Yet still, we are given the absurd argument by the company that the most junior distributors in the scheme are just personal consumers.
This argument is nonsense and also leads us to the law.
The Koscot test is simple. In order for an MLM to be legitimate it must produce evidence that it generates retail sales to ultimate users who are not part of the company's pay plan. For the test to have any teeth, internal consumption does not count as a retail sale. This is the law. This is the case law that the FTC applies when prosecuting pyramid schemes. It is not illegal to sell product to distributors for personal consumption. Let's make that point clear. It is illegal to run a pay plan where the incentives cause participants to focus their efforts on recruiting v. retail sales to ultimate users.
Can there be any doubt that the entire Herbalife pay plan focuses on recruiting and developing new participants into Supervisors? Of course not.
Do we find evidence on YouTube of Product Training seminars and retail sales methodologies or do we find an endless array of videos that teach people how to recruit?
What does common sense tell you?
The logic behind the law is simple. If we bundle the demand for the product with the pursuit of a business opportunity how can we know whether or not individuals are buying the product for its intrinsic value or because, as Webster v. Omnitrition states, because they become "caught-up in their plan for success".
In the specific case of Herbalife, how to do we know that individuals are buying product to get skinny vs. to get to SUPERVISOR?
The answer has to be and can only be obvious. The only way to determine what the intrinsic demand for the company's overpriced shake mix is would be to separate it from the business opportunity entirely.
Of course, this is not how the Herbalife business model works. And so, the company has a problem and it knows it has a problem.
How has the company addressed this problem?
To date, we have seen some modifications through the company's "Build it Better" program. The company's return policy has become more liberal. Some of its training guidelines have been stepped-up. Ostensibly, this all seems benevolent. Until, of course, one considers that the following sinister dynamics remain unchanged.
1) The company's recruiters continue to exaggerate earnings claims and overstate the probabilities of economic success to new recruits when discussing the business opportunity.
2) The company continues to charge different wholesale prices unlike other MLMs to Supervisors and Junior Distributors thereby discriminating against a segment of its salesforce and leaving the financial incentive to inventory load while striving for SUPERVISOR intact.
Has anyone bothered to wonder, how much product would the company actually sell if everyone was charged the same wholesale price? How much product would new recruits buy if there was no financial incentive/discount earned if you get to Supervisor?
3) The company fails to disclose that the mathematical probabilities for business success as a retailer are slim and none. While the company's buyback policy may make an entrepreneur whole for unused inventory it will never reimburse a person for lost start-up costs, wasted human capital, and the opportunity cost of an alternate career choice let alone damaged relationships and reputational loss.
4) Apparently, the lead generation businesses operated by the company's most senior distributors remain up and running as the company continues its time-tested recruiting tactics.
5) The company still imposes no limitations nor restrictions on the number of distributorships and/or Nutrition Clubs it allows by territory therefore deliberately underwriting market saturation.
Longs like John Hempton make the argument that if we can demonstrate that a can of Formula 1 shake mix is personally consumed then we can conclude that Herbalife is not a pyramid scheme. John visited Nutrition Clubs, evidently saw a bunch of straws being sucked and concluded that Mr. Ackman's thesis was bunk.
However, sometimes in life what you see is not what you get. I have no doubt that there are people out there in the real world consuming Herbalife product. I am sure there are even legitimate weight-loss consumers who are on a diet plan. I make no quarrel with the notion that some people may actually find that Formula 1 has value as a consumer product.
Still, common sense tells me that these people are the exception rather than the rule.
Why, for example, would an overpriced shake mix that cures obesity only appeal to low-income people with a heavy demographic skew towards certain affinity groups?
Why are there no Nutrition Clubs in places like Short Hills, NJ or Greenwich, Connecticut if Formula 1 is the miracle cure for obesity?
If the product is so dynamic and wonderful, why aren't distributorships granted scarcely v. gifted away to anyone with a heartbeat and $59?
If I had the right to sell a unique product as a legitimate retailer into a healthy demand curve, why would I recruit somebody to compete with me for customers in my hometown and then invite them to similarly recruit additional competitors?
If the product is successful as a retail sku, why does the company emphasize recruiting in all of its training materials?
Why doesn't the company charge a fortune for territorial licenses v. give them away for little to nothing?
If the law requires a legitimate MLM to have retail sales to ultimate users, why doesn't Herbalife have a retail tracking system like Tupperware?
The answer, of course, is because Herbalife is a pyramid scheme. Participants engage in the purchase and sale of the product as an adjunct to the pursuit of the business opportunity - a business opportunity that doesn't exist due to saturation.
The company's main product is not Formula 1, it is the American Dream - more specifically the company's most successful product is the sale of its supervisorships. Why would you bother to buy one? To get rich of course. That is the scam.
The product has limited intrinsic value in and of itself. If it didn't the distribution model would not be as perverse as it is today.
Investors who think people buy Formula 1 because it is the miracle cure for global obesity are, in my view, delusional. People buy Formula 1 because they think that doing so is an integral part of a get rich scheme that emphasizes recruiting and not retail sales to ultimate users.
The idea that people join Herbalife primarily to get a discount for personal consumption is a myth.
Understanding this mythology makes it easy to see why HLF is a pyramid scheme.
Investment Thesis: Herbalife is a global pyramid scheme that will be shut down by regulators because its compensation system leads participants to emphasize recruiting over retail sales to ultimate users.
Participants at the bottom of the pay plan make no money and churn out only to be replaced by new, unsuspecting recruits.
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.