Herbalife (NYSE:HLF) common is ticking along in the $50s right now. Q1 earnings are due before the end of April. Longs seem unconvinced that regulators will do much more than give Herbalife a wrist slap. This strikes me as an optimistic expectation for a company that is, quite possibly, one of the greatest financial frauds in history.
Recall, the short thesis is that Herbalife is an Endless Chain recruiting scam that uses an overpriced placebo as a device to extract capital from "business opportunity seekers" with false promises and a rigged confidence game. The spoils of this confidence game are then securitized, packaged-up by Wall St. and sold to secondary market investors who risk their hard-earned capital too in pursuit of the free cashflows/dividends the scheme throws off.
Executives make multiple millions of dollars every year. So, too, do the company's most senior recruiters. Meanwhile, the victims at the bottom of the pyramid churn like a Cat 5 Hurricane absorbing economic and reputational loss plus the opportunity cost of actually pursuing something worthwhile with their scarce human capital.
In this article I would like to try to demonstrate how obvious it is that Herbalife is a confidence game with a simple proposition.
Q. What if Herbalife manufactured Coca-Cola (NYSE:KO)?
Imagine if you will that overnight, Herbalife obtained the marketing license for Coca-Cola's secret formula and had the unique and exclusive opportunity to sell this product.
Q. How would they take this product to market?
Longs argue that Herbalife Formula 1 is a branded product with meaningful equity/intrinsic value as a cure for global obesity that is purchased and consumed because it is differentiated from other shake mixes like SlimFast.
Shorts argue that Formula 1 sells billions of dollars worth of product every year because low-income business opportunity seekers are trying to earn their way to SUPERVISOR within the Herbalife pay plan as the marks in a global confidence game.
Q. What would happen if we dropped Coca-Cola into the top of the Rube Goldberg machine that is the Herbalife pay plan?
How would participants behave?
To begin, let's pretend you are John Tartol. You are a senior guy. Maybe you live in California. Right now, there ain't nobody in your territory.
You have the rights to sell Coke.
a) share that right with other people for less than $100
b) encourage them to then also share that right with other people for less than $100
c) encourage them too to share that right with other people for less than $100 or
d) preserve and protect that license for yourself so that all retail sales in California belong to you and you alone?
Next, let's imagine you are Leslie Stanford. Maybe you still live in Canada. Maybe you want to build out a multi-level salesforce to service retail customers in the Provinces of Alberta and British Columbia.
Q. Would you:
a) hire an endless chain of recruits
b) want those recruits to compete so hard for customers that the actual retail selling price of Coca-Cola falls to cost plus 15%
c) Guarantee absolutely no territorial rights to your salespeople or
d) make your distribution licenses expensive, exclusive and territorial?
Next, let's imagine you are Des Walsh. You are the president of Herbalife North America. You notice that the sales of Coca-Cola skew almost exclusively to low-income Latinos around the USA.
a) view this data as indicative of Coca-Cola's broad appeal?
b) be satisfied and proud that your marketing plan begins and ends with an affinity group?
c) try to delude investors that your brand equity has global reach or
d) recognize that your product's appeal is tied almost exclusively to the sale of your business opportunity
Finally, let's imagine you are Michael Johnson. You look at your 10k and realize that you have communicated to shareholders that those who try Coca-Cola for personal consumption typically stay with the business for less than a year.
a) consider your brand a success?
b) be satisfied with the lifetime value of each customer?
c) consider yourself a success as a marketer? or
d) acknowledge the limitations of your product's equity and your distribution model?
If Herbalife sold Coca-Cola instead of Formula 1 there is little to no chance the company would operate a pyramid scheme for a marketing plan.
- The product itself would have brand value.
- Sales licenses would be expensive and exclusive not ubiquitous and effectively free
- Distributors would want to protect their rights to distribute from competition, not sell them to anyone with $59 and a heartbeat
- Participants would be reluctant to recruit too many people in their downline not obsessed with the idea of proliferating and churning and endless chain.
- Consumers would be found not only in affinity groups and low-income neighborhoods but broadly around the country and the world.
- Consumers would also consume the product for longer than a year.
Q. How do we know Herbalife is a pyramid scheme?
The answer seems quite straightforward. All we have to do is to imagine how the marketing plan would function with a product that has real brand equity.
Q. Why hasn't Unilever adopted Herbalife's pay plan for SlimFast? Why hasn't this model for distribution been copied? Is it because Unilever doesn't want to sell more shake mix? Or, is it because Unilever is a legitimate enterprise while Herbalife is an illegal pyramid scheme?
I wonder to myself too, why hasn't Unilever (NYSE:UL) sued Herbalife along with the recent batch of class action attorneys? Doesn't the company have a duty to protect its own shareholders from harm?
Or does Unilever obviously know that the only reason Herbalife sells so much shake mix is because it is conning income seekers around the world?
Herbalife is a pyramid scheme that has adopted Formula 1 shake mix as its central device to get people to open their wallets. The product has 80% gross margins plus a shipping and handling upcharge. Almost all of this gross margin is invested in distribution incentives that encourage participants to deliberately and intentionally recruit an endless chain of recruits to the point of market saturation.
The carnival game begins with the promise of great riches from upline testimonials of great success that are the exception and not the rule. Getting to SUPERVISOR is the "gateway to the Marketing Plan". Like rats in a Skinner's Box, new recruits blindly follow the marketing plan that quickly separates them and their money. Recruiters perfect the game with a relentless stream of encouragement. "You can do it!", "Just try harder", "Are you ready to earn what you're worth?" But of course, the carnival barker knows up-front that the game is fixed. 90% never succeed. Few make any money at all.
If Formula 1 were just like Coca-Cola consumers would be clamoring for the product all over the world, Herbalife wouldn't need an eleven layer salesforce to peddle its wares. If Formula 1 was the legit cure for global obesity, certainly, the company wouldn't have to pay out such a high percentage of its gross margin in distribution costs. Distributors who actually held a license to sell the product would be selling to retail customers not wasting their time trying to recruit competitors.
Honestly, can you imagine a car dealer asking one its customers if they would like to get into the business of selling cars - just down the street - for a song? The entire premise is absurd.
Argumentum Ad Absurdum
In order to understand why Herbalife is an obvious product based pyramid scheme all we have to ask ourselves is "How would it behave if it were not?", "How would it sell Formula 1 if it were a legit product and not a deliberately overpriced placebo?"
Using this approach, evidence of the scam is obvious.
Make no mistake, Herbalife's main product is the sale of The American Dream. For most participants, the pursuit of the dream becomes a nightmare. The central incentive is the pursuit of wealth.
The company deliberately promotes an endless chain of recruits and deliberately encourages market saturation. Regulators will shut it down.
Because Mr. Preet Bharara, the FTC, the Illinois AG, the NY AG and most other regulators too are all "smarter than a 5th Grader."
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.