All seems somewhat quiet on the Herbalife (NYSE:HLF) front of late. The stock seems to be stuck around $60 per share, or a $6 billion market cap.
Is $6 billion the PV of all future cash flows that will be delivered to HLF shareholders? If you believe that then you must believe that Herbalife is going to last as a going concern for a very long time. I will assume the math behind this assertion is obvious. This argument didn't end well for Fortune High Tech Marketing.
This week, I spent some time researching the term "franchise fraud." Lo and behold, I discovered the term at the FBI's website. The FBI has a fabulous website that itemizes many of the frauds the Bureau investigates. By now, Herbalife investors should know that the FBI is on the Herbalife case. As to who placed surveillance microphones at HLF HQ, that is anyone's guess.
One can't help but feel that the level of paranoia in El Segundo right now must be sky high. Is Des Walsh Iago to Michael Johnson's Othello? Et Tu John Di Simone? How many inside whistleblowers might there be? Certainly if I worked in El Segundo I wouldn't trust anyone.
The FBI publishes a web page titled "Common Fraud Schemes" which can be found here.
Here's what they have to say about pyramid schemes.
As in Ponzi schemes, the money collected from newer victims of the fraud is paid to earlier victims to provide a veneer of legitimacy. In pyramid schemes, however, the victims themselves are induced to recruit further victims through the payment of recruitment commissions.
More specifically, pyramid schemes-also referred to as franchise fraud or chain referral schemes-are marketing and investment frauds in which an individual is offered a distributorship or franchise to market a particular product. The real profit is earned, not by the sale of the product, but by the sale of new distributorships. Emphasis on selling franchises rather than the product eventually leads to a point where the supply of potential investors is exhausted and the pyramid collapses. At the heart of each pyramid scheme is typically a representation that new participants can recoup their original investments by inducing two or more prospects to make the same investment. Promoters fail to tell prospective participants that this is mathematically impossible for everyone to do, since some participants drop out, while others recoup their original investments and then drop out.
Tips for Avoiding Pyramid Schemes:
- Be wary of "opportunities" to invest your money in franchises or investments that require you to bring in subsequent investors to increase your profit or recoup your initial investment.
- Independently verify the legitimacy of any franchise or investment before you invest.
Perhaps I have been asleep at the switch, but I think the FBI's website does the best job I have seen yet describing exactly what a pyramid scheme is and how it defrauds marginal recruits.
We have used the term "The American Dream" to describe what Herbalife truly sells. We have also used the term "business opportunity." In effect, what Herbalife really sells is franchises. What is unique about Herbalife's franchise offering should be well known by now. Herbalife franchisees get no territorial rights whatsoever. Franchises are sold ad infinitum through the proliferation of an endless chain. The focus of the business is recruiting. Retail sales to ultimate users are not measured nor tracked.
Herbalife franchisees pay $50 - $100 for a license. Then we are told they have no obligation to buy anything else. This is about the silliest argument I have ever heard. Can you imagine paying a fee to run a McDonald's and then deciding not to buy any French Fries?
Anyone running a franchise needs inventory (Duh). Herbalife kindly offers investors a 50% discount if they are willing to buy $3000 up front. Oh yes, and you also get to qualify for recruiting overrides too with a fancy SUPERVISOR title. By now, investors are well-informed that most of HLF's franchisees make little to no money at all. Why? Could it be simply that there are too many of them?
Aggregate demand for Herbalife product reduces to an average of about $2,500 per distributor around the world. That is not a lot of cheese for so many mice. Still, Herbalife's Pied Pipers continue to proliferate their mathematical fallacy to anyone with a checkbook and a heartbeat.
Q. Is selling a franchise to an investor that offers little to no chance of financial success a fraud?
A. Of course it is.
Q. Can the mice chasing the cheese still produce an awful lot of economic activity in pursuit of the fallacy?
A. Of course they can.
When John Hempton goes to a Nutrition Club he is taking a "Balance Sheet" view of the business, a snapshot if you will. To clearly see the Herbalife con in all of its glory, one must look at the business on a flow basis. From this vantage point, certain data points immediately pop out; most notably the churn in the salesforce, the absence of any income for most of the participants and the reliance upon geographic expansion and perpetual recruitment to sustain the velocity in the business model.
Q. If Herbalife sells such a great franchise, why do most of its franchisees fail to pony-up a measly $10 to renew on the anniversary of their enrolment?
A. There's no money to be made.
Shakespeare wrote in Romeo and Juliet "A Rose by any other name would smell as sweet."
In pyramid scheme speak, "... a Rose by any other name is Franchise fraud" aka an endless chain aka a confidence game.
The sooner regulators shut it down the better.
The good news is the FBI gets it, along with the FTC.
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.