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Two days ago, I published an article on Herbalife (HLF) outlining the criticisms of the company and pointing out some new language in their 10Q which, in my opinion, came across as overly defensive. Since then I have received several questions regarding some of the things management said in the earnings call which, on the surface, seem to answer some of the questions often posed by critics. It is important that investors understand what was actually said on the call and differentiate that from what I believe was implied.

First, CEO Michael Johnson said the following regarding the company's efforts to provide some detail as to who is purchasing its products:

"We recently engaged Lieberman Worldwide Research, one of the top market research companies in the world, to conduct a survey to help develop a better understanding of Herbalife consumers in the U.S. This survey reported that there are approximately 5.6 million U.S. households that bought Herbalife products in the last 90 days. Of this number, less than 10% of the households said they were an Herbalife distributor."

First, it should be noted here that management cannot be blamed for investors' incorrect reading of the above-cited statement. However, I believe management knew how the statement would likely be interpreted by most people.

The statement says that out of 5.6 million households that purchased Herbalife products in the past 90 days, around 90% of those households reported that they were not distributors. What that statement does not mean is that 90% of the products sold by Herbalife in the past 90 days were purchased by households who were not distributors. This is a critical distinction.

The important question which the company did not answer is this: What percentage of the total products sold were sold to the 10% of households who did report being a distributor. Management's statement was, upon close examination, largely meaningless because, again, it provided no breakdown of where the majority of the products were going. In fact, common sense would seem to dictate that most households who buy Herbalife products don't buy very much compared to households who are distributors (buying in bulk after all, is what a "distributor" does). If those 90% of non-distributor households only purchased a small amount of products relative to the 10% of households who reported being distributors (which is almost certainly the case), the actual breakdown could be that the 10% of households who reported being distributors hold the vast majority of the products, which, the reader will kindly recall, is one of the criticisms of the company.

Second, Michael Johnson says the following about 'end consumers":

"Today, for example, we know that 20% of our U.S. volume is shipped directly from Herbalife to the end consumer who is not a distributor."

Again, this statement could technically be true, and management cannot be blamed for investors' incorrect interpretation. However, I believe again, that management likely knew how that statement would be interpreted. The way the statement is worded, it sounds like what Johnson means is that end consumers simply call up Herbalife and order products which are then sent to their front doors straight from Herbalife -- no distributor or interaction with the multi-level marketing part of the business is necessary. That is not correct.

Upon calling Herbalife's toll free number, what one discovers is that you can only order through a distributor -- there is no direct ordering. The distributor then passes your address along to Herbalife who then sends the product to you.

What's the big deal? The big deal is that one wonders why Herbalife doesn't just say that, because if the 20% number is, in fact, true, it is a strong argument in favor of the company's legitimate business model. I believe the reason the company worded the statement the way it did is to make it appear as though end consumers do not have to deal with distributors who might attempt to sign them up into the distributor network.

But perhaps the most interesting thing about the 20% statement, is that when one asks the Herbalife phone rep how to get products shipped directly to your door from the factory, the phone rep will tell you that the local distributor takes your order and address and passes it along to Herbalife who then sends out the product. In other words, Herbalife must know at least some statistics regarding how many of the products are being consumed outside the network, after all, they send out the products straight to non-distributors homes. But this seems strange because just two months ago, in response to the question "... 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?" the company said this:

"We don't track this number and do not believe it is relevant to the business or investors."

Now I guess it depends on how you define the term "track," but based on the 20% figure given in this quarter's call which is the amount shipped directly from Herbalife to consumers' doorsteps, they do indeed have access to that level of detail, and assuming they use computers, the number is indeed "tracked" somewhere.

One final observation about what was said in the earnings call. Towards the end, the company's CFO John DeSimone says the following regarding share buybacks (emphasis mine):

Since the inception of the company's first repurchase program in 2007, we have repurchased approximately $1.5 billion of stock at an average price of $28.58, and together with dividends, we have returned a total of approximately $1.9 billion to shareholders since 2007. As a continuation to our approach of returning excess cash flows to our shareholders, yesterday we announced that our board of directors has approved a new five-year $1 billion repurchase authorization.

In the very next two paragraphs, the CFO says this (emphasis mine):

It is our intention that this new repurchase program be funded from future earnings and, if needed, the credit facility ... yesterday we announced a $500 million expansion of our existing credit facility in the form of a term note that is coterminous with our revolver. The purpose of the expansion is improved flexibility and liquidity as the majority of our revolver was utilized to execute the recent repurchase agreement.

So the new credit facility is being used to pay-off the revolver on the existing credit facility which was itself used to buy back shares. Essentially then, the company took out a loan to buy back the shares, then took out another loan to pay off that loan, and now says it may ("if needed") use the remaining balance of the new loan to buy more shares. This doesn't sound like "returning excess cash flows to shareholders" to me. It sounds like returning other people's money to shareholders and incurring debt obligations along the way which, of course, the company must pay interest on in the mean time.

In order to be balanced and fair, it should be noted here that in the current low rate environment, many firms may find it attractive to borrow at low rates and use the funds to buy back shares. Nonetheless, investors should be aware that when the company claims to be returning excess cash flows, it is not being entirely transparent about where the funds for the share repurchases are coming from. In fact, if one takes the time to go back and look at SEC filings going back to 2007, it is apparent that borrowing money to repurchase shares is quite customary for Herbalife (see here, and here). In fact, I think it useful for investors to look at the following two quotes side by side in order to understand the contradictory nature of the assertions:

From this quarter's call: "Since the inception of the company's first repurchase program in 2007, we have...returned a total of approximately $1.9 billion to shareholders ... [demonstrating] our approach of returning excess cash flows to our shareholders"

From the 2011 10K: "Our existing debt has not resulted from the need to fund our normal operations, but instead has effectively resulted from our share repurchase and dividend activities over recent years, which together, since the inception of these programs in 2007, amounted to approximately $1.3 billion."

As you can see, these two statements do not match.

Connecting the dots here, investors should understand that despite their contentions to the contrary, it appears Herbalife does indeed have information about how much of its product is consumed outside the distributor network. However, judging by its reluctance to plainly state what those figures are, it seems that the numbers might, if they were forced to light, prove that not much of the product is consumed by end users who are not distributors, reinforcing the contention that Herbalife is more focused on recruiting distributors and facilitating the endless distributor network than selling products to end users. This would be a decidedly bad revelation as it could draw scrutiny to the company, something a multi-level marketing company which has already been judged to be in operation of an illegal pyramid scheme in Belgium certainly does not need.

As for the financing of share repurchases, taking out debt to finance buybacks is a form of financial engineering. It does not benefit shareholders in the way buybacks from excess cash would because the company incurs debt (which is of course, detrimental to the balance sheet) and the company must pay interest on the loans which is a drain on cash flow. Additionally, if the company is wrong about the valuation of the stock (i.e. if they bought back stock because they thought it was "undervalued") and the stock falls below their purchase price, they are now in debt for the price of the original purchase and losing money on the shares. To further illustrate the point, here is what ratings agency Fitch has to say about share buybacks funded with debt:

"Share repurchases often signal problems in the underlying business: Whether due to a slow-growth environment, competitive pressures, product-cycle issues, or simply weak operating execution, lagging return-on-equity performance is often a catalyst for more aggressive financial engineering. The combination of these factors, together with higher leverage resulting from large share repurchases, could portend further long-term credit deterioration beyond the initial re-leveraging."

I believe it is important that investors understand all of these things as it demonstrates the importance of taking a critical, analytical approach to reading transcripts of earnings calls and SEC filings before making a decision about an investment. Furthermore, I believe the considerations discussed here provide further support for the idea that, long term, a short position in Herbalife could pay off nicely.

Source: Herbalife: A Careful And Important Look At This Week's Earnings Call