In the wake of Herbalife's (HLF) second quarter earnings release yesterday, there seems to be some confusion as to what the criticisms leveled against the company constitute.
First it should be noted that David Einhorn never confirmed he had a short position in the company, so the idea that the company is 'hurting' Einhorn by repurchasing its own shares is a straw man argument.
Second, neither David Einhorn nor anyone else that I am aware of is arguing that Herbalife doesn't actually sell product. It is not a question of if the company is selling product, it is a question of who exactly is doing the buying. The standard response here seems to be that it doesn't matter who is buying the products--"money is money" so to speak. The problem is, in the case of multi level marketing companies, who is buying the product is really the only important question. This makes it particularly peculiar that Herbalife would say (in reference to its omission of low-end distributor breakdown in its 2011 10K) that
"...we did not include the percentages from the 2011 Form 10-K in our more recent filings because we do not view the information as valuable to the business or to investors."
It is difficult to adequately convey how absurd a statement that is. It is absolutely critical information to both investors and the company as the breakdown of who is buying the product is a way for the company to show that there are retail customers consuming the products and thus prove that the focus of the company is on selling actual products to customers and not on perpetuating the endless recruitment of new distributors. Of course, the company undoubtedly knows this and the idea that the breakdown isn't valuable information certainly begs the question as to why to breakdown was ever provided in the first place. If it wasn't valuable information to investors, why was it included in 10Ks from 2008, 2009, and 2010.
Additionally, Herbalife was judged to be in operation of a pyramid scheme in a Belgian court, and has been accused of the same thing in the U.S. Notably, the Belgian court analyzed the compensation structure and concluded that (emphasis mine):
"...the distributor in the sales network of Herbalife can get more profits out of the indirect profit payments, Royalty Overrides and production bonuses who are calculated over the sale of products by the under their in the network situated distributors as by the profits out of the direct sale of products to the consumer. The [extension structure] prioritizes therefore the extension of the network."
Indeed, consider the following quote from a Herbalife manual quoted by the court (emphasis mine):
" A second way of profits at Herbalife is the recruiting or duplication of persons. This is at first sight an under estimated system of financial gain, but in fact maybe even more important than the profit on the direct sale."
In other words: there is more incentive to recruit other distributors than there is to sell the product directly to customers. This is why the breakdown Einhorn asked about is so critical.
The contention that the company 'refuted' Einhorn, or otherwise proved him wrong by reporting solid Q2 results is false and misleading. A refutation of Einhorn (and other critics) would have been including a detailed breakdown of the distributor base in the 10Q and providing some new level of transparency on the issue (for instance, what portion of products are sold outside the distributor network). While the company did file an 8K after its first quarter earnings report which disclosed the distributor breakdown for fiscal 2011, predictably there is no mention of how the 'distributor base' breaks down in the most recent 10Q and there is certainly no mention of what portion of the products are sold outside the network.
There is one new thing in the 10Q however that is particularly telling. Under Item 2 in "Management's Discussion And Analysis Of Financial Condition And Results Of Operations" the following paragraph appears:
"Our sales are generated primarily from distributor purchases that are for reasons other than any requirements to earn multi-level compensation under the company's marketing plan. The majority of our distributors have not sponsored another distributor and do not earn compensation relating to products sales made by or to other distributors. We believe these distributors have joined the network for reasons other than participating in our multi-level compensation plan such as personal consumption and reselling products to others"
This language is new to the company's 10Qs--it does not appear in filings before this quarter. One certainly wonders why the company would suddenly feel it necessary to include language which, for all intents and purposes, says 'we are not a pyramid scheme.' The new paragraph seems overly defensive.
Additionally, while the new language asserts that 'the majority of the company's distributors have not sponsored another distributor', this doesn't necessarily mean that the majority of the company's revenues do not come from sales leaders.
Of course, figuring out exactly how much revenue comes from who is an absurdly complex exercise given the company's compensation structure. In fact, it is impossible to know how much of the company's sales come from outside the network because the company says it doesn't track this number. From the 8K:
Question #1 from David Einhorn: "First, how much of the sales that you'd make in terms of final sales are sold outside the network and how much are consumed within the distributor base?"
Answer: "We don't track this number and do not believe it is relevant to the business or investors."
So just to be clear here: Herbalife does not believe it is important to track the amount of its products being sold to people outside of its distributor network. In fact, Herbalife doesn't even think this number is relevant.
Until Herbalife can provide answers to critics beyond saying that the criticisms aren't relevant, the shares will continue to be risky. Many good short ideas take quite a while to pay-off. While a short position in Herbalife could be an exercise in pain and futility in the short-term, it could end up paying handsomely in the long-run.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.