Herbalife: No Retail Profit?

Jul.14.14 | About: Herbalife Ltd. (HLF)

Summary

What is the 'No Retail Profit' claim?

What methods exist for determining retail profit claims?

What does the evidence suggest about retail profit?

This is my Fifth article about Herbalife (NYSE:HLF) in my "Can We Talk?" Series. Previous articles have focused on areas that were not being addressed by other authors. This article will offer up a completely fresh topic with the purpose of opening discussion and inviting meaningful comment.

So, what is the "No Retail Profit" issue all about?

Simply stated, there are assertions that Herbalife shows no retail profit (aggregating all retailers) and that this premise is a basis for classifying Herbalife a Pyramid scheme or some other equally bad characterization. The implications for anyone invested or investing in Herbalife cannot be overstated. Herbalife will be dead if it is a Pyramid and if not ... well the stock will likely jump.

Well, to me, it's sort of like arguing over how tall Sasquatch is, when his existence is still in doubt. So I thought it would be reasonable to address whether or not the premise can be reasonably believed, rather than "how tall" it is.

Let me start off by saying there are three ways to examine the possibility of "No Retail Profit":

1) Absolute Analysis: This entails auditing more than 500,000 members. This task is so burdensome as to rule it out as a method that anyone would undertake.

2) Statistical Analysis: This is less precise and would only require a representative sample and produce a result within a statistical margin of error. Such analysis would require access to members and Herbalife and is beyond the ability of average investors ... most likely beyond the ability of any investor.This is possible and could be employed by the FTC or some other agency with the necessary access and resources.

3) Inductive Analysis: This concept may be new to many readers. It would take pages to explain all the nuances, so at the risk of generalization I will keep it as simple as possible. It is the drawing of a generalized conclusion based on what evidence is available. It is not certain, an inference, sort of like walking down a path and seeing where it takes you.

Since the first two methods are ruled out, let's see what evidence exists and where it leads us?

First I need to make some assumptions. Here goes...

1) 30% of Product Purchased is "inventory build". I use 30% because it exceeds what most anyone attributes to HLF and the maximum inventory build that would not run afoul of HLF's rules and the Amway "Safe Harbor" .

2) Profit. While everyone seems to define this as selling price minus buying price, I think that is not fully reflective. There are some costs (gas, telephone, stamps, etc.) the retailer incurs. In CPA jargon ... SG&A. A part-time business, run chiefly out of home should have minimal SG&A. For these purposes I assume it is 10% of product cost or goods (COGS).

Though I draw on much more information than just Herbalife's statements, let me start with Herbalife's "Statement of Gross Earnings for 2013".

It identifies four types of members:

1) Single Level Members without a downline. This consists of members for which the rewards include wholesale pricing for personal consumption and the opportunity to make retail sales. 73% claim to have joined mostly for the discount on personal consumption.

2) Non Sales Leaders (SL) with a downline. Same as above plus the added potential for Royalty income from the downline.

3) Sales Leaders without a downline. Wholesale pricing for personal consumption, the opportunity to make retail sales and Wholesale profit on sales to members.

4) Sales Leaders with a downline: Same as above plus Wholesale profit on sales to members and "Bonuses".

What can we infer from this? Let's deal with each group, separately. I'll start with the easiest one.

1) Sales Leaders: This group purchases product from HLF for one-half Suggested Retail Price (SRP). They can sell to members (wholesale) at .75 SRP or Non-members (retail) at 100% SRP. Let's look at two outcomes, each assuming 70% of product purchased is sold (30% inventory build).

We can compute potential profit per package as:

Wholesale = (70% times .75 SRP) = .525 SRP. Now the costs are computed at .55 SRP (50% COGS plus 5% SG&A). Result for wholesale = a loss of 2.5% SRP (.525 minus .55).

Retail Sale= (70% times 1.00 SRP) = .70 SRP minus .55 SRP. Result for retail sale = a net profit of 15% SRP (.70 minus .55).

So, we see that a Sales Leader will make a 15% profit on retail and a 2.5% loss on wholesale. This isn't surprising as we can intuitively surmise that selling at full retail profit is better than selling at the reduced wholesale profit. So, the Inductive Analysis path seems to be heading in the right direction.

This brings us to a critical question; what is the mix of wholesale and retail sales required to show a profit?

Easy answer, one retail sale for every six wholesale sales, and the Sales Leader is profitable.

Let's look at Herbalife's numerical data for the USA. They claim 408,000 distributors and 115,000 Sales Leaders. that means, on average, each Sales Leader is assigned about 3.5 distributors.

So, if Herbalife's "10 person rule" is adhered to, the average SL would have at least 6.5 retail sales for each 3.5 wholesale sales, easily fulfilling the "profit threshold" and approaching a 12% combined overall profit. However, if there are "dirty tricks" and the "10 person rule" is mis-reported, it would have to be mis-reported by 85% of Sales leaders. Not JUST misreported but grossly misreported, so much so that the 85% have no retail sales.

But, who knows, it could be... I'm sure the "No Profit Vigilantes" think so.

Additionally, the base assumption was that the 30% inventory build was worthless. What if there were no retail sales? Could the inventory build be sold at a discount to create an overall profit? If so, what would it take to turn an overall profit"?

Here's a table illustrating different inventory levels that could be sold and the maximum discount rate necessary to convert the potential SL loss into an overall profit.

Inventory Sales vs. Discount rate
Inventory Volume Sales Discount to SRP
100% 92%
75% 89%
50% 84%
25% 68%
Click to enlarge

What the table illustrates, is that a Sales leader could "fire sale" 100% of the inventory (all 30%) at a 92% discount and overcome a complete lack of retail sales, turning an overall loss into overall profit.

Take note .... this is NOT selling at 92% of SRP, it is selling with a 92% Discount (8% SRP). If the product retails for $20, the Sales Leader could sell it for $1.60 and construct an overall profit. Of course, if it was sold for more, a bigger profit would result, or the SL could simply halt selling and maintain inventory.

If the SL only wanted to sell 25% of the inventory, the Sales Leader would offer a 68% discount (selling at 32% of SRP) to show an overall profit.

This is not the only method that the SL could utilize to overcome a potential loss as a result of no retail sales. There is another consideration. I assumed a 30% inventory build. What would the inventory build need to be, to overcome no retail sales? The answer is 27% instead of 30%.

Interim Conclusion: What this exercise is intended to show is the plausibility of Sales Leaders showing no retail profit. It is possible, but would require a "Perfect Storm". That is, 85% of the Sales Leaders reportedly meeting the "10 Person Rule" would have to grossly misrepresent this requirement; and, there would have to be less than one retail sale for every six wholesale sales; and, inventory would not be able to be sold with a 92% discount; and, inventory build would have to be no less than 27%.

So, at least as far as Sales Leaders go, the proposition that retail sales show no profit is not plausible.

But, admittedly, this is only a partial picture. We must now turn our attention to Distributors, not Sales Leaders. Is it plausible that they show no retail profit?

2) Distributors: There are two categories of Distributors, those that self consume and those that don't. Let's first look at those that don't self consume.

Non-Consumers: This group can have only one objective, making sales to consumers. Using the same methodology as with Sales Leaders, but adjusting for a higher cost of product, we would find the following:

Consumer Sale= (70% times 1.00 SRP) =.70 SRP minus .825 SRP (75% COGS plus 7.5% SG&A). Result for sale = a net loss of 12.5% SRP (.70 minus .825).

This also seems intuitively correct. Those that don't use the product and rely solely on making retail sales have been thought to have a profitability issue. Once again, the Inductive Analysis seems headed in the right direction.

A 12.5% loss is a substantial loss to try to overcome. As with the Sales Leader, less inventory build could provide the necessary profit. What would the inventory build have to be to show a profit? Answer, instead of 30%, 17.5%.

If substantial reduction in inventory was the only way to show a profit, it would cast some doubt on the "non-consumer" profit prospects. However, it doesn't tell the whole picture. If a non-consuming distributor was unable to sell product, they could just return it for a full refund. After all, would someone keep large amounts of product when they could return it? Actually, they don't even have to return the entire 30% to be profitable, just returning 42% and keeping the rest will do.

Or, if they wanted to, they could sell the entire 30% inventory at a 62% discount to SRP and show an overall profit. But, I have to ask myself, why would one sell inventory build at a 62% SRP discount when they could just return it at a 25% SRP discount rate?

Interim Conclusion: The likelihood of a non-consuming Distributor showing no overall profit is considerably higher than a Sales Leader. It wouldn't take a perfect storm. They would have to decide that they don't want to return a portion of their inventory or fail to find buyers on eBay, Amazon etc. at a 62% Discount to SRP or fail to do some combination of the two.

Once again, a possible outcome, but not a plausible outcome.

Let's now look at those distributors that consume.

3) Consumers: This is a little different approach. We start with the assertion that they are looking for a discount and sales are a secondary concern.

Let me dispense with those that have no interest in sales and only want the discount. Well they get 25% off. One could argue that this should be viewed as profit to them, but let's not dirty the water and leave this sub-group completely out of the picture.

That leaves us the "consumer-seller". Let's assume this sub-group purchases 130% of the amount they plan to consume. That gives us the 30% inventory build.

First things first ... what is the cost of the 30%? Answer: it costs NOTHING. If they didn't join as a distributor they would have paid almost the same amount of money for less product. Actually, instead of paying 100% SRP as a non-member they only pay 97.5% SRP for the whole 130% bundle. They earn 2.5% SRP profit without selling anything.

Furthermore, any product they sell is total profit. That's right, total profit. The 30% cost them NOTHING. Let me give an example, so this becomes as clear as possible.

"Consumer" wants to buy $200 SRP of product. If they don't "sign on", it costs $200. If they sign on and buy 30% excess, it costs 130% times .75 times $200 = $195. They have a $5 savings and 30% free product to sell.

What is interesting about this, is if the SV suggests they buy this 30% extra product the "Consumer" can buy it without risk. As long as they remain a consumer, they are ahead the $5 plus anything they get from product sales is a "freebie".

Interim Conclusion: The Consuming-distributor is a pure retail profit center. By joining as a distributor versus a non-member, inventory build is free. Whatever they do, they're ahead.

CONCLUSION: There is practically no data available that can determine whether or not HLF retail shows/doesn't show a profit. So one must either resign themselves to having no practical answer or making lots of assumptions, speculations and who-knows-what.

But there is one method that can offer insight, one investigators use all the time, and that is INDUCTIVE Analysis. Think in terms of Police Detectives arriving at a crime scene. Unless they have proof positive, such as a video of the crime, they gather clues and evidence and try to piece together the story they tell. If the clues point in a direction they follow it and see where it leads. Seldom do they have all the necessary pieces, but that doesn't preclude their ability to get close enough to reach a plausible result.

The advantage of inductive analysis is that it doesn't rely on all manner of assumptions, speculations and conjecture. It can function with large data gaps. It simply takes what is there, and sees where it goes. Sometimes it misses by a country mile and it's pretty obvious when all arrows point in different directions. Sometimes everything points in the same direction and the results are uncannily plausible.

Even with the dearth of available, relevant, data this article needed to utilize only two very bland assumptions. Maximum inventory build and SG&A. There are no assumptions as to any particular sales levels, price points or other critical factors that would require specific data that, it turns out, isn't available.

As far as the influence of the maximum inventory build assumption, if it was lowered it would lead us to the same result, only more forcefully. If SG&A was removed, it would also just lead us to the same result, only more so.

We do not need to know or make assumptions as to how much of what is sold to whom, when and at what price. Instead, we are able to create a range of possibilities and events and evaluate the probability that they can be achieved.

For instance, we don't need to speculate on how much inventory is sold on eBay and at what price, by whom and to whom. Instead, we are able to create a model that enables us to assess how eBay and similar outlets directly influence profitability.

Furthermore, at each step on the path, Inductive Analysis is intuitively validated. Retail profit is better than wholesale profit; non-consuming distributors have a large potential loss; maximum levels of inventory build result in SL losses on wholesale; refunds are integral to offset excessive inventory and selling inventory at a discount can result in increased profits.

So, where do we end up. Simply stated, the "No Profit" scenario may be justified. There is a possibility it is correct. On the other hand, it is not a plausible outcome.

Furthermore, "No Profit" cannot be logically asserted without making assumptions about critical components such as actual product sales, price levels and volumes with absolutely no hard data available to back them up.

So, any investor on the long side has plausible reason to discard the "No Profit" theory and look a little more optimistically. The "shorts" may find they need to find a better argument.

Housekeeping: I've tried to deal with a complex subject in as simple a manner as possible. I took some "shortcuts" and will address them now.

First, I used 25% and 50% profit modules for the Sales Leaders. The actual structure runs from 8% to 50%. Though this will affect the Sales Leaders numbers, the overall effect is negligible because any reduction in the discount to the SL is reflected in correspondingly bigger discounts to the Distributor. The overall picture is unchanged, it just shifts the beneficiary.

Likewise, I use 25% discount for the distributors when it can run from 25% to 42%. Same reasoning, any increase in their discount is reflected in a corresponding decrease in the SL profit.

Second, Consumers can get discounts to SRP without having to become distributors. This would seem to mitigate the "freebie" scenario. Not completely, for two reasons.

a) Any product they purchase from eBay, Amazon, etc. will be from some member's inventory build. So, if a Consumer buys product on eBay, the inventory build for the seller is reduced. As a result, the Consumer is factored out of any profit equation. Yet their purchase infuses the total price into the inventory build, increasing the selling members profits.

b) We are looking at Profit for those that join as members. We need not concern ourselves with those that don't. Just as Wal-Mart looks at its profit based upon its customers. They don't factor in what someone purchased at Macy's.

Third: SLs or distributors might sell product for larger discounts. This would impact their profit profile. However, these sales could be allocated to inventory build while they still look to retail 70% at full SRP. Remember they have 30% that is unaccounted for and selling it at a discount is a good thing. They can also mix and match consumption, sales or returns to achieve a variety of financial outcomes.

We must remind ourselves that there is no available data that indicates that this occurs to any great extent. It is merely a suggestion, a speculation, an hypothesis. Any assertion is mostly anecdotal and this is exactly the type of argument Inductive Analysis tries to avoid.

Fourth: It is possible that any SL or Distributor could run their business in a non-businesslike fashion and incur losses that could or should have been avoided. For instance, they could ignore refund policies, alternate sales outlets, incur excessive expenses, etc. This should not and is not reflected in any computation as it is an anomaly.

POST SCRIPT: As I was following the "inductive path" there was a second fork in the road that I briefly followed. It ended in a completely different subject that is not related to this article, so I backtracked and took the "no Profit" fork. Notwithstanding, this other fork is worth mentioning.

It seems that the focus should be on retail sales, not recruiting. I'm not saying it is, just that it should be. Recruiting distributors out-scores retail only when inventory builds are at excessively high levels. Levels so high that one would be playing with "Pyramid Fire".

Now, we all know upline rewards are egregious distributions of Royalty Income, but inductive analysis points to the same result when analyzing retail/wholesale profit.

So, an inductive formula exists that indicates that the path to riches in HLF is through retail sales by SVs, not through recruiting even first level distributors. Those that concentrate solely on retail are more than twice as likely to outperform those that offer wholesale pricing to create a downline.

So, my advice to any SVs out there is if you are given the opportunity to recruit a first generation distributor or sell them retail for their consumption, sell them retail and move on.

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.