As I write this article I am sitting in a hotel in Costa Rica, Central America staring over the jungle canopy at a volcano. The volcano's summit is surrounded by clouds. It is hard to tell if it is just a mountain or a volcano. When the cloud cover clears, the answer becomes clear. The open summit reveals it's true nature. Even as it poses as a mere mountain this wonder of nature is truly volcanic. Behind Herbalife's (NYSE:HLF) veneer of legitimacy lurks a pyramid scheme of epic proportions. Once the clouds have cleared the truth will be revealed.
Costa Rica is a beautiful country with beautiful people. It is also one of Herbalife's Latin American markets. When you land here at Liberia airport and begin to drink in the culture of this democratic country, the idea that shake mix is a critical part of its economy immediately becomes absurd.
Yesterday we started to see evidence of this absurdity in Herbalife's quarterly results. Forget the fact that Herbalife booked its Venezuelan results at an 11:1 exchange rate v. 50:1 for Tupperware (NYSE:TUP). Forget that EPS missed by 2 cents. Forget that revenue missed by 30 million.
Forget that on April 28, 2014 management guided Wall St. to 7-9% growth in Volume Points and 10-12% growth in revenues only to disappoint less than 65 days later. Forget the fact that whatever guidance management now offers for the balance of this year should obviously be treated with skepticism.
The most critical takeaway from Herbalife's release is simple - pyramid schemes don't grow to the sky.
You see, pyramid schemes have life-cycles just like a Mayfly or an elephant. The life-cycle of a pyramid scheme is simple. Like an endless chain letter, recruiters expand the number of new recruits ad nauseam until the point of saturation is reached. This occurs for Herbalife geography by geography around the world. As long as the flow of new recruits into the pyramid exceeds the flow of torched recruits exiting the back door the business looks healthy. Until, of course, saturation levels are achieved.
Q. Do we see evidence of saturation in Herbalife's results?
A. Of course we do.
For starters, HLF's Membership base is stalling out.
- 3.7 million at end of 2013
- 3.9 million at end of Q1
- 3.9 million at end of Q2
Herbalife recruited just shy of 1.2 million new "Members" in Q1 and Q2 and yet the needle has hardly moved on the size of the pyramid.
Solving for X it is obvious that 1 million participants failed to re-up for a measly $10 to keep their Memberships. Meanwhile, over at GNC (NYSE:GNC) 70% of their Gold Card members renew annually. Bizarre really that weight-loss seekers would behave so inconsistently from one company to the next. Unless, of course, one company is actually selling a fraudulent business opportunity and not a viable nutrition solution.
Q. Which markets in particular are showing evidence of saturation?
How does this list strike you?
- North America
- South and Central America
Specifically, New Recruits Per Sales Leader By Geography Looks as Follows
- EMEA 1.1:1
- Mexico .6:1
- North America .8:1
- South and Central America 1.4:1
- Asia Pacific 1.2:1
Think of it this way. In Mexico, every single Sales Leader recruited an average of less than 1 new Member each in Q2. Recruiting is Herbalife's pipeline for future results. Recall, the company tells us clearly in its 10Ks and Qs that "Members" typically stay with the company for less than a year. Assume for a moment that all 3.3 million of Herbalife's non Sales Leaders last less than a year and are worth $200 in Life Time Value on a free cashflow basis. This entire customer base is worth $660 million in Present Value. Herbalife investors are paying close to $6 billion for this company's equity. Thinking about it another way, the Sales Leaders and their future recruiting efforts are worth in excess of $5 billion. For those counting, that works out to about $8,333 per Sales Leader. Considering most Sales Leaders quit in Two Years or Less this bid seems a tad optimistic even when we consider just how good the likes of Susan Peterson are at recruiting.
Q. What inevitably kills pyramid schemes?
A. The law of large numbers.
When you have a business that relies upon recruiting new members each and every year-the law of large numbers starts to catch up with you the bigger you get. Today, this dynamic started to catch up with Herbalife - big time.
My guess is that regulators are paying attention. You see folks like Dr. Vander Nat understand the mechanics of pyramid schemes well. Even as the majority of participants languish in the bottom levels of a geometric recruiting pattern it turns out that as long as a pattern of recruitment can be sustained the scheme can continue to proliferate. Of course, as it proliferates inevitable harm is caused to those who sign-up to pursue a business opportunity that is a mathematical fallacy by design, a rigged game if you will, a lottery in disguise with all winnings transferred to those upline.
Yesterday, Herbalife's publicly traded pyramid scheme revealed results that show just how hard it is to sustain a scheme that is churning with the velocity of a Category 5 Hurricane. Trouble is, once you hit landfall it is hard to sustain the winds. Landfall for Herbalife is obvious. They are running out of countries, running out of marks, and the velocity in the recruiting results is slowing down in many parts of the world.
Q. What is the final stage in the life-cycle of a pyramid scheme?
A. Collapse. When recruiters cannot fill the pipeline quicker than the latest victims are leaving the party results turn negative. As in negative YOY or even QOQ comps. Negative Volume Points in the US and Mexico is likely just the start of what is to come.
Inevitably, regulators will be very interested in arresting this potential outcome sooner than not.
So, where does that leave you if you are a Herbalife long?
When you wake-up this morning you own equity in a company with an insolvent balance sheet that at best is a busted growth stock with a management team with little to no credibility that is being investigated by no fewer than 7 regulators while exhibiting all of the hallmarks of a global pyramid scheme of epic proportions.
The company has run out of share buyback pellets having looted the balance sheet accordingly.
The two largest shareholders are now trapped in a long squeeze. (17 million shares anyone? Bueller?)
Mr. Ackman and his team continue to pursue their efforts to relentlessly expose the company's fraudulent representations to Members and Investors alike.
Q. If you are long: How many new victims do you really think are going to try to climb Mount Supervisor from here on out per annum?
Where are all of these people going to come from?
Is it more likely that Herbalife's growth will now reaccelerate or is the next phase in the life-cycle of this particular pyramid scheme collapse?
My money is on the short side. The life time value of a "Member" less than a year is a huge fundamental tailwind. As for the rest of the thesis.
Inevitably, I expect regulators to arrest this madness sooner than not.
In the interim, as the wonderful people of Costa Rica like to say - Pura Vida!
Disclosure: The author is short HLF. 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.