When I started my "Can We Talk" series, it was my intention to open up for discussion areas that are overlooked by other writers. This article will continue that purpose.
Let me start off by saying that readers looking for an article that makes a simple claim that Herbalife (NYSE:HLF) is or is not a Pyramid will be disappointed, as this article reaches no conclusion either way. Instead, it will focus on one of the most misunderstood and misapplied fragments... the Vander Nat Formula.
Who is Vander Nat, and what is his formula?
Peter Vander Nat is the chief economist at the FTC. He is acknowledged as an expert in Pyramids and MLMs. In 2002, he authored an article in the Journal of Public Policy & Marketing that explored marketing fraud. This has become a centerpiece of Pyramid litigation. I encourage serious readers to read the entire document.
Vander Nat recognized that the case law and regulations surrounding Pyramids were vague. He proposed a formula with the express intention to try and distinguish legitimate MLMs from Pyramids.
Vander Nat's basic premise is that a Pyramid exists if the "rewards" are based primarily on recruitment rather than actual sales to end-users. He then puts forth a formula, with variable inputs, that is designed to test for Pyramid vs. MLM.
Vander Nat makes a very important "leap". He introduces the concept of Advanced Retail Commissions (ARC). Look at this way, more familiarly, as "draw against commission". He says that if the monies paid are ultimately generated through sales volume, they are simply advances. The formula then tries to quantify if these advances are actually supported by sales or are coming from another source... namely, "recruitment".
Before we get deeper into the formula and its variables, let's first look at how Vander Nat has been applied by the bulls and bears.
First, on the BEAR side, Ackman used Vander Nat's concept of "Primarily" in making his charges against Herbalife (slide 60 of his presentation). Need I say how many bears view this as a revelation?
Second, on the BULL side, Fusion Research, in an article for Seeking Alpha, attacked Ackman's assertion as having ignored the formula. Fusion plugged Herbalife's numbers from the Annual Report into the formula, and determined it passed the Pyramid test. Fusion's article has become a rallying cry for many in the bull camp.
So, who is right? Who is accurately portraying Vander Nat's concept and formula? The answer is... neither.
Let me clarify. Ackman fails to take into account the formula, and just uses the verbiage "primarily". In essence, he takes Vander Nat's premise and doesn't follow it through as intended. By ignoring the conclusion and accepting only the preamble, he makes what can be construed as a flawed analysis.
Fusion, on the other hand, is flawed in simply plugging numbers into the formula, failing to take into account the verbiage accompanying the formula. To understand Fusion's flaws is a little more complicated, so we need to understand exactly what Vander Nat says and how it was misapplied.
This means we have to get into specifics... there is no other way. I'll do my best to keep it in a format that can be easily understood.
Vander Nat's Formula, in its quest to determine if sales revenues can support "rewards", needs to look at Herbalife's profit per product. This means revenues and expenses. Here's where it gets "tricky".
One of the formula variables is represented as "f" = FULL Production Costs.
Problem... what is FULL doing there? Production Costs is a known accounting term. By adding FULL, it would mean that it is something more than just Production Costs.
What does Vander Nat say about this? Well, two definitions, neither of which is consistent. FULL Production Costs are:
1) "Manufacturing costs and directly related company expenses",
2) "Wholesale cost and immediately related expenses for providing product to its distributors"
The problem with these definitions is not just that they are not identical, but they aren't terms that find their way into financial statements.
Herbalife's Annual Report uses the more accepted accounting terms of "Cost of Goods Sold"(COGS) and "Sales, General and Administrative" (SG&A). Without getting into accounting "lingo", neither of these are actually Production Costs (nevertheless FULL), though COGS comes close.
Now, what puzzles me is that certainly Vander Nat must be aware of the usual terminology incorporated in financial statements. After all, he is a renowned economist. Why would he have not just used COGS (which excludes indirect costs), instead of "coining" a completely new metric... FULL Production Costs... and then defining it with two different parameters?
The only explanation I have is that he was trying to get to something more than COGS, something he wasn't even to sure how to explain. I think he just couldn't get his arms around some variant, and this is how it surfaced. Since I'll never get the opportunity to cross-examine him, what it is will have to be answered by someone else.
Now, back to Fusion Research. When they "plugged in" the numbers, here's what they did (note: f=FULL Production Cost):
"... f = (Direct production cost)/(Wholesale price) = (COGS)/(Net Sales)..."
Look closely, they changed Vander Nat's definition from FULL Production Cost to DIRECT Production Cost, and then changed it, once again, to COGS.
They had to do this because FULL Production Costs isn't a financial reporting term, nor are Vander Nat's conflicting explanations.
That means, quite simply, that Fusion's result is uncertain.
Now, let's look a little further into what Vander Nat says about the utility of the formula itself.
He is very clear that the utility of the formula is in identifying what he calls "cut-points". That is, it will identify when a MLM is clearly not a Pyramid and when a Pyramid is clearly not a MLM. But these "cut-points" lie at the extremities. In between is the "gray area", where it is inconclusive and other, non-formulaic factors must be considered.
This is important, because if we look at the calculation performed by Fusion (assuming the COGS is valid), the outcome is right on the border, just making it into the non-Pyramid side. A small difference could move it one way or the other. It certainly is not at the extreme levels Vander Nat envisioned when he qualified the usefulness of the formula.
CONCLUSION: Vander Nat's Formula must be read in context of the entire paper in which he presented it. To simply pull out a phrase, as Ackman did, and base a conclusion on it adulterates the fine work Vander Nat put forth.
On the other hand, to simply plug in numbers, adjusting as convenient, ignoring Vander Nat's own reservations, is equally adulterous.
The Vander Nat Formula can certainly identify cases like BurnLounge and Amway, but has very limited value in businesses like Herbalife.
The paradox is that the formula was designed with the intention of clarifying the factors present in MLMs and Pyramids, and all it really did was conclude that those situations that are the most in need of clarification cannot be reduced to a formula... at least not in this way.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.