This week Nu Skin (NYSE:NUS) and Herbalife (NYSE:HLF) investors were treated to yet another installment of Australian Hedge Fund Manager John Hempton's thoughts about MLMs here. John compared the working capital cycles of these two companies and concluded that Herbalife is healthier than Nu Skin. "Look at all that free cashflow!" John gushed. Of course, this exercise would be analagous to placing an elephant and a hippopotamus on a scale in order to point out that the hippo is less heavy.
Mr. Hempton blocked me on Twitter this week and called me a racist. This allegation strikes me as ironic for someone invested in a company that targets Latinos with the sale of a mathematical fallacy. Still, as any good psychotherapist will tell you - we must learn to forgive others for their own dissonance. John continues to cling to the notion that Herbalife sells lots of meals annually and offers a comforting and psychologically rewarding weight loss service to obese people around the world. Herbalife is "just like McDonalds" John argues. This might be true if only McDonalds committed franchise fraud too.
"What's the harm?" John might say. Then again, isn't that the central question in the argument?
Agencies like the FTC are set up to prevent harm to businesses and consumers. They regulate fraud, anti-trust violations, marketing deception, etc. The idea is simple. In order for markets to function efficiently and effectively, consumers and producers should not have to navigate through a labyrinth of deception. There should be an expectation that counterparties and competitors act in good faith or, if you prefer, legally.
When parties in the macro-economy break the law, harm is caused.
People will inevitably misallocate their resources based upon fraudulent misrepresentations and deception. Capital is then transferred from the honest participant to the dishonest one.
This is the essence of fraud.
It is also unfair to ask a legitimate marketer like GNC or even POST to compete with a company that sponsors a prohibited marketing scheme.
Mr. Hempton continually focuses his analytical attention on the experience of people consuming Herbalife shake mix. "Look" he says. "There's a value proposition there. This stuff actually works." (to paraphrase)
This may be true. Herbalife may actually deliver value to its end consumers whomever they may be and wherever they might be. Still, this is hardly the point of Mr. Ackman's allegation. In order to uncover the fraud at Herbalife one has to look at the experience of the business opportunity seeker. These are the people the company targets with recruiting videos like this. These are the people the company's South American operatives target with programs like this.
(Source: Pershing Square, The Big Lie)
These are the people who are invited to participate in an Endless Chain Recruiting festival that now operates in 91 countries around the world. These are the people taught to behave like this.
These are the people being harmed.
Pointing to evidence that Herbalife's products are consumed does not defeat the obvious statistical evidence that the vast majority of people who pursue the Herbalife business opportunity fail.
Q. What does this evidence look like?
Now, this may surprise you but Herbalife's crafty CFO doesn't really provide a schedule in the 10Ks and 10Qs revealing the company's churn/failure rates. Fortunately, with some basic algebra and a touch of forensic accounting as analysts we can figure it out.
Since the end of 2007, here's what the data looks like "in practice".
Negative 7.4 million distributors. Now that's what I call harm!
Regulators of all stripes are probing Herbalife right now. The question I like to consider is which agency will be first to stop the harm and how will they do it. Spotting the harm is the easy part (unless you're Australian). Gathering evidence, preparing legal briefs, booking court time, etc. is a process that takes time.
What is exciting to me is the array of options available to regulators. As August is now winding down, perhaps it might be worth looking to AuQuest to see what an injunction can and may look like. Turns out the California Attorney General's office thinks little things like tracking retail sales, tying commissions to retail sales, etc. are important if you want to lay claim to the title of MLM. The AuQuest injunction can be found here.
Here's the point. If regulators want to shut down the apparatus of a company that emphasizes recruitment over retailing then they have the power to do so.
Herbalife, of course, is a different kind of animal for regulators to deal with. Because it is a public company the array of potential securities violations committed by the company is significant. The sheer size and hubris of the fraud is indeed mind-numbing too.
Still, every time I question whether or not HLF is a confidence game I just remind myself of the churn rates in the sales force and the obviousness of the Money Transfer.
After all, this is what mathematical fallacies are designed to do. "I told two friends, and they told two friends, and so on and so on and so on..." leads you to results like this:
(Source: Pershing Square, The Big Lie)
This is what saturation looks like "in practice".
Herbalife recruits millions upon millions of people and then asks them to compete versus one another for market share. This is like the world's largest WWF cage match where only the promoters make money. 37,000 nutrition clubs in Mexico might also just be a clue that the supply curve for salespeople is being pushed out a wee bit too far.
Mr. Hempton sees no harm in Herbalife's 10ks and 10Qs. He sees efficient working capital cycles and healthy free cashflow. Could it be, John, that this is the data that management wants you to see? Aren't the public filings just the tip of the iceberg, so to speak?
Contemplate the accounting for Venezuelan results and one starts to get the picture (4% of revenue pure fiction, adjusted eps too high, cash on hand overstated).
Contemplate this idea too. When the FTC imposed a Final Order on Futurenet, here's what it had to say about commissions related to training activities:
"Compensation related to recruitment" is any form of compensation that is conditioned upon, derived from or related to recruitment of new persons to any business opportunity involving any multi-level marketing program. This term includes, but is not limited to, compensation paid or provided to participants in a multi-level marketing program as a result of or relating to any type of training provided to either new or existing participants in a multi-level marketing program."
Funny how the company has never mentioned how many people have enrolled in Club 100 nor reported their "Consumos" to investors as recruiting rewards. Hmm?
Herbalife has known since the day it went public that regulatory intervention was a material business risk. This is the reason they are opaque and cryptic and shifty and cagey. This is why their quarterly conference calls aren't open to critical investors of all stripes anymore but are rather staged PR events. Ms. Adler from Barclays has taken over from Mr. Ramey as the analyst du jour to take up the Herbalife cause.
Though, I have to hand it to Herbalife President Des Walsh I must say. This Irishman makes Eminem seem mono-syllabic when it comes to fielding questions from media and analysts and spinning the message to favor his firm. Mr. Walsh expects a "return to growth" later this year. Remember that "forward-looking statement" when we look back on HLF's results at the end of this year.
Unfortunately for Mr. Walsh, however, his gift of the gab is unlikely to overwhelm Dr. Vander Nat's calculator nor the following facts about Herbalife:
- Most Distributors churn out of the business
- Most receive no compensation from the company
- Those at the Top of the Pyramid make Most of the Returns
This, of course, is how geometric progressions work. Over 80% of participants get trapped in the bottom levels of the sales force. Death of these salesmen and women is predetermined.
Will August turn to AuQuest for Herbalife longs?
Which regulator will step up to the plate first? Or will it be a task force?
We'll have to wait and see. LULAC and Senator Markey and other consumer activists are also watching too.
In the interim, if you want to learn what's really going on with Herbalife here's some advice. Be wary of the financial filings. Be wary of what management tells you. Be wary of Mr. Hempton's observations. The veneer of legitimacy may be hazardous to your portfolio.
Herbalife is a global confidence game that promotes an endless recruiting chain in 91 countries around the world. The sooner it is shuttered the better for society.
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.