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Summary

  • Bronte Capital blog post misses the mark.
  • Pyramid schemes are endless chains.
  • Herbalife remains a short.

There are many interesting characters in the Herbalife (NYSE:HLF) story. One is a Hedge Fund Manager from Australia named John Hempton. I have traded a few barbs with Mr. Hempton over the internet. His opening salvo to me was to call me a "clueless shortseller." I accept this mantle with distinction. I also note, Mr. Hempton is long and I am short HLF common.

Yesterday, the "thunder from down under" published a lengthy post on his blog related to the "personal consumption" dilemma for Herbalife. John seems to think that if he can see, touch and feel personal consumers with his "on the ground" research then it is impossible for Herbalife to be a pyramid scheme.

I submit that this analysis is both simplistic and erroneous. In this article, I would like to summarize the reasons why. Whether or not I can convince John to protect his shareholders' capital or not is up to him. Still, it seems apparent to me that the good ship Herbalife is an obvious pyramid scheme.

_____________

Dear John,

I read your blog yesterday and submit that your grasp of the Herbalife pyramid scheme allegation is mired in the grips of a false choice. The "Personal Consumption" question may lead you to churn your unit holders' capital unnecessarily. I attempt to articulate the reasons why in this letter.

I write to you to argue that your long position in Herbalife is, simply, the wrong side of the trade. Here are the reasons why.

I think we can both agree that Herbalife manufactures for sale an array of nutritional supplements from its facilities in the USA. The product that sells the most is called Formula 1 shake mix. This product is a chalky powder that is, as far as I can tell, undifferentiated from many other protein powders available to consumers on a chemical basis. Substitutes are available both online and on the shelf of various retailers for lower prices.

Still, Herbalife manages to sell billions of dollars of this product annually around the world. The company amplifies the value of its over-priced shake mix in 3 ways.

1) It hires Nobel Laureates, etc. to provide testimonial evidence as to the product's efficacy.

2) It sponsors Athletes and Athletic Clubs around the world to give the product a veneer of legitimacy/distinction and

3) It sells a business opportunity to an independent salesforce that is responsible for selling the product.

To understand why Herbalife is a pyramid scheme, we must only zero-in on the mechanics of the pay plan that promotes the business opportunity. I will concede the point that you may be able to visit a Nutrition Club and see an obese person consuming Herbalife shake mix. I will concede the point that Herbalife, in all likelihood, has some retail customers. My point to you, however, is that none of these data points overwhelms the notion that Herbalife's Marketing Plan is a pyramid scheme. Here are the reasons why.

I would hope that we can agree that when Herbalife goes to market to sell its product it has an array of choices available to it as to how it wants to peddle its wares. A franchise model would be one option. Selling direct over the internet would be another. Selling wholesale product to bricks and mortar retailers would be another. However, Herbalife has selected Multi-Level Marketing as its distribution model of choice. Legitimate Multi-Level Marketers promote the recruitment and support of distributors such that said distributors can develop and sustain a profitable, retail business where retail gross margins cover all fixed and variable costs and generate a reasonable return on capital for the investor in the business opportunity.

Herbalife is not a legitimate Multi-Level Marketer for one simple reason. Its compensation plan promotes an endless chain of recruits and its distributors are always recruiting.

By design, the Herbalife comp plan emphasizes recruiting over retailing as the road to prosperity. The obvious fallacy embedded in the business model is the simple idea that the opportunity set for distributors is infinite when in fact it is obviously finite.

Consider your native Australia as an example. How many distributors can a country like yours legitimately support? What would be a reasonable ratio of distributors to retail customers such that distributors could have a profitable business? Would it be 50:1 or 100:1? I am sure we could both make reasonable assumptions.

Q. Does Herbalife's marketing plan make any efforts to limit recruiting activities by geography as and when a given market is saturated? Or, does the pay plan continue to promote a relentless chain of new recruits even when a market is over-serviced?

The answer to this question is obvious and can be found in the company's public disclosures. Put simply, Herbalife recruits to the point of pain and then continues to recruit well after the point of pain has been reached.

All of this recruiting is done with the relentless proliferation of a big lie. Senior recruiters like John Tartol and Doran Andrey and Leslie Stanford tell new marks that the road to riches is available to them too if they just work hard enough. Of course, this entire promise is total nonsense. Once a geography is saturated there is no "business opportunity" to be had.

How do we know?

For starters, all empirical evidence tells us that the market clearing retail price for Formula 1 is roughly 35% to 40% off SRP. This tells us that the laws of supply and demand work and work well. Because Herbalife sells too many distributorships, pricing power for salespeople has collapsed to a level where only a Supervisor could ever expect to make any retail contribution margin at all. Entry level distributors are totally up a gum tree and have no chance to compete against their upline brethren for retail profits.

Second, the company's churn data is instructive. If Formula 1 was a successful product that produced lots of legitimate retail sales and a high return on capital for distributors, we should expect the turnover in the salesforce to be low. Instead, we see exactly the opposite. Close to 100% of the distributor base turns over every year or two. Why? Saturation

Third, recruiters are so desperate to find recruits that they sign-up personal consumers as Distributors in the hopes that they, too, will gestate into recruiters themselves. Why do they do this? Because the Herbalife Pyramid Scheme indoctrinates all participants to recruit. The road to riches is not as a retailer, it is as a recruiter. John, have you built out your downline yet?

Fourth, the company's recruiters continue to peddle nonsensical recruiting tales in Opportunity Meetings to prospective business opportunity seekers.

Q. If these recruiters actually told these prospects the truth, do you really think anyone would sign up?

Fifth, less than 1% of Salespeople make any money. Need I say more?

Sixth, a simple test. What happens to the P&L if the company stops recruiting tomorrow?

I am aware that you visited a Nutrition Club in Queens, NY. Were you also aware that this particular zip code is totally over-saturated with Herbalife distributors?

Q. What business owner with a conscience would unleash such a sinister and Darwinian pay plan? Do we see 4 McDonald's on every street corner or 4 Exxon stations? Of course not. Why? Because the opportunity set for any given distributor license is finite.

When you sell more licenses to distributors than a marketplace can absorb you are committing fraud. It's just that simple.

Herbalife's pay plan is a pyramid scheme for a very simple reason. By design, it promotes an endless chain of new recruits. It does this by:

  • Exaggerating the nature of the opportunity upfront in controlled settings
  • Paying commissions on channel stuffing vs. retail sell through
  • Discriminating on Price vs. its Distributors in order to create the incentive for Inventory Loading
  • Granting Licenses to Sell to anyone with $59 and a Heartbeat
  • Allowing unlimited levels in the company's downline and
  • Emphasizing constant recruiting vs. the support and promotion of real and sustainable retail operations the world over.

Does Mexico need 30,000 Nutrition Clubs, John? How many salespeople does Melbourne need? Why are distributors in Queens, NY tripping over one another while I cannot swing a cat and hit a distributor here in Short Hills, NJ?

The answer should be somewhat obvious.

Herbalife is successful in areas where low-income people need a "business opportunity." This is where the rags to riches nonsense the company sells takes root. This is where the crime proliferates. And, make no mistake, it proliferates to the point of pain.

Herbalife's pay plan is designed to saturate. It is designed to incentivize recruiting over retailing. It is designed to be an endless chain. It is designed to promote inventory loading. It is designed to sell "The American Dream." Demand for Formula 1 is driven by people who are caught-up in the pay plan and their pathway to success. Most fail within a year.

It is this specific design that makes Herbalife's Marketing Plan a pyramid scheme that meets the Koscot test and it is this design that should get regulators to shut the pay plan down.

If you are long HLF at the moment, you have to consider what Herbalife might look like in a post regulatory world.

Is it likely regulators will give the company a clean bill of health?

Will they shut them down?

If not, what changes might they impose upon the Marketing Plan?

How might those changes change the final demand for Formula 1?

I submit to you that once regulators take away:

  • Herbalife's ability to price discriminate and therefore
  • Harpoon the company's ability to sell Supervisorships and therefore
  • Murders the perverse incentive that new recruits have today to inventory load
  • While also cracking down on "rags to riches lies"
  • And usurious lead generation campaigns that exist off balance sheet,

you and your investors will learn something important. What you will learn is that Formula 1 has very little intrinsic value in and of itself when separated from the perverse and relentless sale of a business opportunity that simply cannot exist for marginal entrants because the pay plan is a confidence game.

Why?

Because Herbalife is a recruiting company first and a product company second. Take away the velocity in the model and the scheme will collapse on itself.

If you can table a compelling argument as to how and why Herbalife does not sponsor an endless chain of recruits around the world I am all ears. If the 6 million distributors who have resigned from the pay plan over the past 5 years doesn't give you pause for thought then I am not sure anything will.

Until then, I hope your long argument swings on something more significant than the company's new buyback policy and your ability to see obese people sipping shakes through a straw.

Final thought. Picture yourself living in a small town in the Australian Outback. You have a license to sell Formula 1. Would you:

a) Protect that license to capture all retail sales in town for yourself

or

b) Recruit your next door neighbor to compete against you and encourage him to recruit his neighbor too?

Doesn't the answer swing on whether or not the company that grants your license attaches some territorial exclusivity to your contract and/or where you sit in the upline/downline?

Herbalife's pay plan has no speed limits. Ergo, it's a money transfer scheme, a fraud, and a con that will be shut down by US regulators.

Caveat Emptor doesn't apply when fraud is at work.

Put another way, Mr. Ackman is right.

Sincerely,

Matt Stewart

"Clueless Short Seller"

Source: Letter To John Hempton From A 'Clueless Short Seller'