We are initiating a short position in USANA Health Sciences (NYSE:USNA) at an average price of $40 per share. Stop loss set at $44. We noted previously that we were watching Herbalife (NYSE:HLF) after David Einhorn grilled the company regarding its breakdown of sales among its sales associates and actual paying customers.
Herbalife hemmed and hawed after being confronted with Einhorn's questions and our guess is that Einhorn is most certainly looking at HLF as his next target (it could be unveiled at the Ira Sohn conference next week).
Problem is that we see a lot of headline risk now with a short on HLF and are taking a back door approach by shorting USNA - one of HLF's competitors - and from what we can tell one that allegedly appears to be bending the rules even worse than HLF. Plus, while HLF got slaughtered on the Einhorn revelation - down 33% - USNA didn't take quite the beating.
USANA, like competitor Herbalife sells, nutritional supplements, foods and other healthcare products. The company does not sell direct to consumers and relies instead on "associates" to hawk its products.
New associates are required to purchase a starter kit for $29.95 from USANA and in order to start earning commissions are required to purchase from USANA at least 200 points worth of merchandise (a point is approximately $1.20, so roughly $240 just to start earning). This number is 400 points if you elect to open three business centers. Read more about the comp plan.
Like other MLMs, USANA associates are encouraged to aggressively recruit new associates, so that they can build their "downline." I won't get into details here, but in my conversations with former USANA associates, the sales meetings at USANA are heavily focused on the recruiting as opposed to actual sales of the product.
In order to continue earning commissions, associates are required to purchase at least ~$120 (or 100 points) worth of product every four weeks - or $1,560 worth of product per year. If you opt to run three business centers, that number increases to required 200 points every four weeks.
In my opinion, the bottom rung associates attempt to stay alive by signing on new associates who are required to purchase overpriced product in order to collect commissions. The majority of revenue made by USANA and the majority of commissions paid (mainly to the top 1% of associates) comes from the hundreds of thousands of distributors who are all purchasing product in order to be "commission eligible" and participate in the business venture. If USANA removed the requirement to personally purchase any product in order to collect commission, the company would be worth a fraction of its current value.
Pyramid Scheme Or Legitimate Business?
Many have called the MLM business model a glorified pyramid scheme, and in all reality it's not too far from the truth. Back in the 70s, the FTC ruled that MLM company Amway was not an illegal pyramid scheme since the Amway system was based on retail sales to consumers.
In the ruling-the FTC noted that Amway was not a pyramid scheme due to several rules that were in place - including the 70% rule that Einhorn referenced on the HLF call. The bottom line regarding the 70% rule is that the distributor should not reorder unless product which has been previously purchased has been passed on to the ultimate users.
The 70% rule is a big deal in the MLM world and while it is not a statute it is inherently a part of most MLM programs. The rule in a nutshell is meant to try and prevent distributors from stocking up on inventory in order to boost or even achieve a level in order to earn commissions. But how many are actually enforcing it?
This is what made the Einhorn questioning so crucial - HLF couldn't give a straight answer on the percentages. This question-and non-answer is really a sign to us that HLF and the other MLM's are in trouble:
So what is the percentage that is actually sold to consumers that are not distributors?
So we don't have an exact percentage, David, because we don't have visibility to that level of detail.
So if Herbalife or any other MLM can't provide us with the percentages of what is being sold and to whom, could it be that the business is being kept alive because of all the new distributors that are added year after year?
First, we would like to define in the words of the FTC what exactly entails a pyramid scheme. According to Debra Valentine, former general counsel for the FTC, a pyramid scheme might look like this (key in on the highlighted text):
They promise consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public. Some schemes may purport to sell a product, but they often simply use the product to hide their pyramid structure. There are two tell-tale signs that a product is simply being used to disguise a pyramid scheme: inventory loading and a lack of retail sales. Inventory loading occurs when a company's incentive program forces recruits to buy more products than they could ever sell, often at inflated prices. If this occurs throughout the company's distribution system, the people at the top of the pyramid reap substantial profits, even though little or no product moves to market. The people at the bottom make excessive payments for inventory that simply accumulates in their basements. A lack of retail sales is also a red flag that a pyramid exists. Many pyramid schemes will claim that their product is selling like hot cakes. However, on closer examination, the sales occur only between people inside the pyramid structure or to new recruits joining the structure, not to consumers out in the general public.
So, now that we have a better understanding of a pyramid scheme, let's take a closer look at some of the numbers at USANA:
- As of year end 2011, USANA had 222,000 active associates and 64,000 preferred customers (ones that are solely buying product and not earning commissions)
- 90% of 2011 sales were from the associates
- Associates (we're assuming that all associates are only running one business center) are required to make a minimum purchase every four weeks of roughly $120 in order to continue receiving commissions
- $120 * 13 * 220,000 associates = $346 million in sales just on these required monthly purchases
- Total Sales for 2011 - $581 million. Meaning that 60% of overall sales are just from the monthly minimum requirement - 60%
Let's get back to that definition of a pyramid scheme:
Inventory loading occurs when a company's incentive program forces recruits to buy more products than they could ever sell, often at inflated prices. If this occurs throughout the company's distribution system, the people at the top of the pyramid reap substantial profits, even though little or no product moves to market. The people at the bottom make excessive payments for inventory that simply accumulates in their basements.
This is indeed alarming, and exactly what Einhorn was getting at on that HLF call. These associates are keeping the boat afloat for USANA and for the top tier associates, who are reaping the profits for the failed endeavors of the new and current associates who are losing money.
And let's not forget the statement from the FTC about sales "often at inflated prices." We intend to provide some further research into the excessive costs of USANA's vitamins, shakes, nutrition bars, etc. Here's the price list for USANA's products.
As an example of the ludicrous prices being charged, check out the Peanut Butter Nutrition Crunch Bars, which for a pack of 14 bars retails for $34.74, or nearly $2.50 per bar. The bars which are 39 grams contain 150 calories, 10 grams of protein, and 14 grams of sugar.
A larger 68 gram Clif Bar Crunchy Peanut Butter Bar can be purchased at Wal-Mart for less than $1 per bar. If we adjust the nutritional values for the ClifBar to those of the USANA bar based on size, the Clif Bar has 140 calories, 6 grams of protein, and 12 grams of sugar. Bit less protein, but lower sugar.
Therefore the USANA bar is nearly 150% overpriced (and 40% smaller than a very comparable Clif Bar) . And this is just one example. 150% seems to be a normal markup for the products, which are not unique or proprietary. I've heard some USANA fans throw out this crazy analogy:
"Well you pay $5 for a box of Girl Scout cookies, and those can be purchased at the grocery store for $2/box."
Very true, but when purchasing Girl Scout Cookies I'm supporting a charity, not a for-profit Multi Level Marketing company.
Let's talk a bit about Associate Turnover at USANA for a moment, something that USANA has failed to provide at any point in any of its SEC filings or conference calls. With the help of USANA Watchdog, we are providing a chart which shows that associate turnover is likely greater than 80%.
The data compared the number of low level associates - Sharers and Believers who also make up the largest portion of overall associates. (This information was taken from USANA reports in 2005 and 2006 - the last time it was made available). In 2005, there were 28,244 Sharers and Believers with on average roughly 50% expected to be promoted to at least a Builder (the next highest level associate). In 2006, we should have seen at least 14,122 new promotions, yet there were only 2,619 promotions, meaning that 81.5% of the initial Sharers and Builders likely dropped out of the program.
Let's also discuss the "Five Customer Rule" which is part of USANA's policies and procedures. Again a big thanks to USANA Watchdog who alerted us to this information. They have a great writeup on the Five Customer Rule. According to USANA:
Associates must develop or service at least five customers every four-week rolling period.
OK, so this means that the 222,000 active associates must be selling to 1.1 million retail customers. (minus 64,000 preferred customers - ones who are just buying product and not earning commissions).
Big problem is that USANA does not actually verify this. In the policies and procedures, they state:
"Associates must retain all retail sales receipts for a period of two years and furnish them to USANA at the company's request. Records documenting the purchases of Associates' Preferred Customers will be maintained by USANA."
From USANA Watchdog:
USANA could not possibly be enforcing the five customer rule because they do not even know how many retail customers the associates have. USANA does not even know the retail customer's names. USANA has no record of associate's retail sales because they don't keep record of it in their database. I believe it is because the retail customers do not even exist.
The following is from USANA's 2007 first quarter preliminary conference call on April 4, 2007:
USANA Q1 Preliminary Earnings Call
Time into conference call - 1:10:47 to 11:11:38
Dave Wentz: "… To say that 14% of our sales is to customers is completely ridiculous and misconstruing the facts and it doesn't also include all of the retail sales that our distributors make on after we get the products to them that we don't have the names. They keep their retail customer lists to themselves and they own those retail customers so to speak, and service them by providing the products directly to them and the company does not know who they are, does not have contact with them. So completely misconstrued allegations."
Doug Lane with Avondale Partners: "There's a component of users of USANA products that you don't even have in your database. Those are the retail customers of your distributors, correct?"
Gil Fuller & Dave Wentz: "Absolutely correct."
My question is this: How does a company that is supposedly in the business of selling a group of retail products not know who or how many retail customers it has? This will likely never be answered by USANA because they know the real truth. The majority of USANA's retail customers are in fact its own associates. The ones that are required each and every month to re-order between $120-$240 worth of products just to continue receiving any commissions.
Are these the hallmarks of a legitimate or ethical business? Not to mention that all of USANA's products are completely overpriced (click here to see the price list) with nothing offered that would be considered unique or proprietary.
There's more to come on this one as we are prepared to offer more and more details on USANA's business and what we see as major concerns. The big note and big risk that we must mention is the short interest for USANA - it's huge as nearly 32% of outstanding shares were short as of April 13th. That's a big number - one that we normally would stay away from. But given what we see as a company that could eventually be labeled a fraud we are willing to take the risk. Be aware that there is a big risk for a short squeeze if any little piece of positive news hits.
Also, there is a huge amount of insider ownership - founder Myron Wentz owns greater than 50% of the company. Plus, the company has increased its share repurchase of late, which could prop up shares in the near term. We're not scared. We think that it's time that investors know the truth about USANA.