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Since the company's second quarter earnings call on July 31 I have written two articles on Herbalife (HLF). The first article reminded readers that most criticisms of the company are based on its perceived reluctance to demonstrate that a substantial portion of its products were sold outside the distributor network and drew attention to new language in the company's 10Q emphasizing its distributors' focus on "reselling products to others". The second article discussed what I perceived to be several ambiguous and perhaps misleading statements made by management on the earnings call regarding its sales to end consumers and drew attention to the fact that although Herbalife claims that its share buybacks are exemplary of an "approach of returning excess cash to shareholders", in fact, the company funds a substantial portion of the share repurchases with loans.

Before continuing, I want to (re)emphasize that no matter what the company or its shareholders and supporters say, the issue of the end consumer is absolutely critical as the company itself notes in its 10K (emphasis mine):

"Our network marketing program is subject to a number of federal and state regulations administered by the FTC and various state agencies as well as regulations in foreign markets administered by foreign agencies. Regulations applicable to network marketing organizations generally are directed at ensuring that product sales ultimately are made to consumers"

Additionally, I invite readers to consider the following statements published by the Bureau of Consumer Protection and the Federal Trade Commission (emphasis mine):

It's best not to get involved in plans where the money you make is based primarily on the number of distributors you recruit and your sales to them, rather than on your sales to people outside the plan who intend to use the products...One sign of a pyramid scheme is if distributors sell more product to other distributors than they do to the public...Another sign of a pyramid scheme is if the money you make depends more on recruiting - getting new distributors to pay for the right to participate in the plan - than on sales to the public.

So in response to the question I often get which asks "Who cares who the products are being sold to as long as the money is there?", I answer: the United States government. The implications for shareholders are clear. If a public company is judged to be in operation of a pyramid scheme by a federal agency, it is safe to say that that company's bottom line will suffer materially. As a discalimer here, let me say that I am in no way, shape, or form suggesting that such an investigation is pending, I am merely stating the obvious: who is buying the products matters.

Herbalife's management knows all of this of course (after all, the CEO appeared on CNBC to defend against the allegation that Herbalife is a pyramid scheme) and indeed, as discussed in my last article cited above, management has gone to considerable lengths lately to address the issue of end consumers. Here I will focus on another of management's contentions from last week's earnings call.

Increasingly, Herbalife has emphasized the contribution of so-called 'Nutrition Clubs' to its business. In a presentation at the 14th Annual ICR Exchange Conference, Herbalife's vice president of investor relations Amy Greene described the clubs at length (this is a long block quote but bear with me because it's necessary to understand what the clubs are):

distributors also recognize that there was a growing need for the ability for people to buy [the products] on a per day basis. And we call that daily consumption... So we had a college professor who is a distributor in Mexico...[who asked us to] please begin [to] package [the products] in daily sachets so I can sell it on a per day basis to these people because that's how they get paid and that's how much money they have. We couldn't do it...He opened the front door of his house, he began inviting his friends and family members to come in and he charged them a membership fee for coming to his nutrition club and while they were there, he served them an aloe drink, a tea and a meal replacement shake. The US Latino distributors...saw this growth happening in Mexico and said we well we need to do it too and so nutrition clubs begin to open in the US...So that was a huge driver of the growth and it is much more efficient for the distributors... Now I go to my club,...people start coming into me and they start handing me money and they start asking for their aloe tea and the shake. customers. So the frequent interaction, people are coming to the club very frequently.

So the 'Nutrition Clubs' are gathering places where people pay a membership fee and they get to socialize and drink complementary shakes. Now somehow, these social gatherings have turned into quite the profit generator. In fact, according to management, they accounted for around a third of the company's U.S. retail sales:

"...30% to 35% of our volume in the U.S. is sold directly to consumers through nutrition clubs."

Now admittedly, this is a bit ambiguous because management uses the term 'volume', and because there is no breakdown of U.S. sales in the 10K (only "North America"), but since we are talking about end consumers, we can probably say for arguments sake that management is referring to retail sales and we can use North America as a rough guide to U.S. retail sales figures. Herbalife's North American retail sales totaled $1.111 billion in fiscal 2011. I will leave it to readers then, to speculate about the amount management must be referring to when it says between 30-35% of U.S. volume is attributable to 'Nutrition Clubs'.

Knowing what constitutes a 'Nutrition Club' and having a rough estimate of how much in yearly sales management claims are made to end consumers through these clubs, I now invite investors to consider the following rules applicable to 'Nutrition Clubs' as delineated in Herbalife's "Nutrition Club Rules":

"Nutrition Clubs are... not retail stores or outlets."

"The design and content of [a Nutrition Club's] sign must meet Herbalife's published standards to ensure that the location is not perceived as a store...or other retail location, and does not invite passersby to purchase product."

"Signs may not directly or indirectly identify, imply or signal that the occupant is an Herbalife Independent Distributor (or otherwise indicate an Herbalife business)."

"Signs may not state or suggest that Herbalife products are available for retail purchase on the premises."

"Signs may not use the terms "Nutrition Club," "Herbalife®,"...or "shake"."

"The following terms, and any similar terms, are not acceptable: ..."mart," "store," or "shop."

"Signs that depict "Open/Closed" may not be visible from the exterior."

"Nutrition Clubs operating in non-residential locations must ensure the interior of the Club is not visible to persons from the exterior, by use of window coverings. Window coverings must be unbranded, and they may not state, imply or suggest (even without words) that retail products are available for purchase inside."

"Nutrition Clubs are not retail locations and operators may not state or imply that they are. It is not permissible to sell product servings to anyone."

So in summation, Herbalife 'Nutrition Clubs' which purportedly account for 30-35% of U.S. volume and where products are sold to end consumers 1) are not retail stores, 2) cannot even have signs which might lead people to be perceive them as retail stores, 3) cannot have signs which could be construed as inviting to retail customers, 4) cannot imply or signal that an Herbalife distributor resides inside, 5) cannot imply or state that Herbalife products are present on the premises, 6) cannot have signage indicating if they are open or closed, 7) must use window coverings to conceal all activity from the public, and, in an irony of ironies, cannot be called 'Nutrition Clubs.' The upshot to all of this? Herbalife will provide nice looking window coverings:

"Herbalife offers a variety of attractive Nutrition Club window coverings which are available at MyHerbalife.com or by request from Distributor Relations."

Now I think it goes without saying that it is quite questionable how any establishment which meets all of the above listed requirements could possibly generate hundreds of millions of dollars in retail sales per year in a single country.

This is just one more example (and a poignant one at that) of why some analysts question what Herbalife says about its business model and sales breakdowns. Furthermore, it demonstrates the absolute necessity of investigating management's claims before coming to a decision about the wisdom of an investment in Herbalife. I continue to recommend (with good reason I believe) a short position in Herbalife until such a time as the company can provide convincing evidence of a robust retail (end consumer) market for its products.

Source: Herbalife, Nutrition Clubs, And End Consumers: A Look At The Company's Rules