Since we are well into the fifth month since Dave Einhorn's May 1st questions on a Herbalife (HLF) conference call, it is time to examine what has happened since that widely publicized event. The share price of Herbalife has dropped significantly including a low share price of $42.15 on May 15th of this year. Even though Herbalife's share price has recovered some, its share price has continued to trade around the $50 range, well below the $73 high it reached on April 23rd of this year.
During the first month of the short attack, almost every article written about the attack on Herbalife always mentioned Einhorn, as well as Lehman Brothers and Green Mountain Coffee Roasters Inc. (GMCR), and gave you the impression that Einhorn was going to lay out the same kind of case that he did about both of those companies. In fact, Herbalife's share price plunged to as low as $45.55 in just the first three days of the short attack mainly based upon shorts anticipating Einhorn's analysis that would tear apart Herbalife's business.
Since Einhorn is into poker and since I know that good poker players study the actions of their opponents to read their hand, I decided to research how he handled Lehman Brothers and GMCR as well as several of the other companies that he shorted. Einhorn's pattern is different from most hedge fund managers who typically never let anyone know they have shorted a stock. After Einhorn has already shorted a stock, within a matter of a few months he publicly explains his position as to why the shares of the company are over priced in a detailed logical fashion. Also, his pattern has been to continue to publicly highlight problems he has found with a company as many times as he can after he begins his attack on a company.
In this ValueWalk article, "David Einhorn's Previous Shorts", you find out that Einhorn started shorting shares of Lehman in July 2007 and then within a few months (see 2nd article excerpt below) began outlining his case against Lehman publicly multiple times.
"In July 2007 David Einhorn made a controversial call, he was shorting Lehman Brothers. He didn't announce that position until April of the following year when the bailing out of Bear Stearns signaled the real beginning of the crash."
In a June 4, 2008 New York Times article "Lehman Battles an Insurgent Investor" you can derive that Einhorn actively began publicly battling his case against Lehman since as early as October of 2007.
"For eight months now, Mr. Einhorn, a rabble-rousing hedge fund manager, has pilloried the venerable Lehman Brothers in an effort to drive down the bank's stock price, which he is betting against."
Another example of how Einhorn announces a short position is demonstrated in the excerpt below from the October 17, 2011 ValueWalk post, "David Einhorn is short GMCR" where Einhorn presents a 110 page detailed presentation explaining why he is short GMCR. Also you can see from GMCR's stock chart on 10/17/11 that the stock dived lower that day. It had been trading in the $90 plus range but plunged to as low as $79.33 and continued down lower in the following days.
"I (David Einhorn) have a short position in this company: GreenMountain coffee. The presentation is 110 pages"
As has been Einhorn's pattern and documented in the below excerpt from the December 20, 2011 article, "Exclusive: An inside look at David Einhorn's "big short", he quickly followed through with his aggressive attack on GMCR after his announcement of being short the stock and has even continued aggressively bashing the company in recent months.
"Hedge fund manager David Einhorn is taking an even harder line against Green Mountain Coffee Roasters (GMCR.O), his big short trade, claiming a recent audit committee review of the accounting issues he flagged is nothing more than a "whitewash.""
Both of these short cases required a lot of detailed analysis by Einhorn and his staff before he shorted their stocks, and was able to make the details of his research known to the public. Also in both situations, he had already shorted the company's stocks before he gave any hint to the public that he was even investigating either company. In Green Mountain's case he instantaneously made the public aware that he had already shorted the stock as well as providing everyone a detailed 110 page analysis of problems with the company. In Einhorn's case against Lehman Brothers, he began publicly laying out his case against them within four months of shorting the stock.
After reviewing some of the other companies that Einhorn shorted, it seemed that the pattern was basically the same. First completely analyze the company to determine all of its shortcomings. Short the company's stock, and then shortly thereafter disclose to the public all of his findings. Here are some excerpts from a January 20, 2011 Toolbox for Finance article, "David Einhorn and Lessons for Creditors from Short Sellers"
"The successful short seller is one who analyzes companies with the rigor of a credit analyst but takes on a bit of venture risk by betting that his timing of the imminent demise of a company is correct."
"The short sellers we are referring to are those who, after shorting a stock, present to the market a clear headed analysis covering issues ranging from the underlying corporate story to the company's reported financials."
Since we have an understanding of Einhorn's pattern, we probably can conclude from Einhorn's questions on Herbalife's conference call, when he mentions comparing the information on the last two 10-K's, that he and his staff had already done a significant amount of research on Herbalife before that May 1st conference call as well as that he might have already been short Herbalife per this excerpt of one of those questions he asked on that May 1, 2012 Herbalife conference call:
"One last question, when you had your previous 10-K, you disclosed three groups of distributors at the low end - you called 29 percent self consumers, 57 percent small retailers, and 14 percent potential sales leaders. Then that disclosure did not repeat in the subsequent 10-K, so I have two questions."
Herbalife responded to those questions with byfiling this Form 8-K with the SEC on May 2, 2012 which included this information answering the above question with numbers that weren't dramatically different than those Einhorn already knew about from the 2010 10-K:
" Discount buyers were 27 percent (distributors who receive a 25 percent discount);Small retailers were 61 percent (distributors who receive a 35 percent discount);Potential supervisors were 12 percent (distributors who receive a 42 percent discount)"
Other than the 2 questions listed below, which were the major questions that Einhorn really wanted to see if the company could answer, all other questions that Einhorn asked were basic questions about distributor rules and how distributors made their money. Einhorn probably already knew the answer to those questions from his prior research. Here are the two most important questions that Einhorn asked on that May 1st Herbalife conference call:
"I got a couple of questions for you, first is how much of the sales that you make in terms of final sales are sold outside the network and how much are consumed within the distributor base?"
"What is the percentage that is actually sold to consumers that are not distributors?"
Obviously Herbalife should have known the answers to those two questions but apparently didn't at the time of the call. Also with my background as a CPA and with over 30 years experience as an entrepreneur, I can understand why Einhorn, even with a significant amount of research prior to that call, would not have been able to have determined an accurate answers to those two questions either. Without having access to Herbalife's books, as well as not having access to information directly from Herbalife distributors themselves, it would be almost impossible for anyone outside of Herbalife to actually come up with those exact percentages.
If Einhorn could come up with a number first challenging that over 50% of Herbalife's sales were made directly to Herbalife distributors for their personal use, he probably thought his information would convince the FTC to dig into Herbalife's books to find out if it was actually true. The importance of determining if over 50% of Herbalife's sales were to non-distributors can be found in the FTC's October 2009 release, "The Bottom Line About Multi-Level Marketing Plans" which stated:
"One sign of a pyramid scheme is if distributors sell more product to other distributors than they do to the public."
Even though Herbalife didn't immediately have those numbers, I am very impressed with how quickly Herbalife's management acted by engaging 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. as well as the actual percentage of sales to non-distributor customers. This decision has already paid huge dividends as documented by these excerpts from "Herbalife's CEO Discusses Q2 2012 Results - Earnings Call Transcript":
Michael Johnson - Chairman and CEO: "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. And 30% to 35% of our volume in the U.S. is sold directly to consumers through nutrition clubs, so over half of our U.S. volume is going to the end consumer through these two business methods. And this doesn't include volume from our traditional person-to-person selling method."
Michael Johnson - Chairman and CEO: "Over the past several years, a growing portion of our business has been driven by our distributors around the world moving to daily consumption business methods with long-term sustainable customers. We believe that daily consumption business methods now generate approximately 40% of our volume. With more than 36,000 non-residential nutrition clubs operated by our distributors around the world, Herbalife products and distributors are more accessible to more customers than ever before."
Excerpt from Analyst John San Marco - Janney: "That's helpful. And then in terms of the U.S., what - I want to make sure I got my numbers right. I think Michael said that 30% to 35% of volume in the U.S. is daily consumption and then I think you stuck to the number that was about 40% of global volume is from daily consumption. Why do you think it is that the U.S. under-indexes?"
Excerpt from Des Walsh, President of Herbalife: "So the answer is, John, because the clubs initially were adopted by our Latino group in the United States, and it was based on the success of the Latino group that then they were adopted within the general market. But that was probably about two years later, and that's why you're seeing that, by comparison, the percentage involved is lower today, but as far as future potential, we're very bullish upon the growth now that's happening in the general market."
In addition to these direct sales to the end consumer, I believe that Herbalife has misclassified sales made to distributors that are strictly for self consumption and who don't have any down line. These distributors need to be reclassified as preferred customers. If they decide that they like Herbalife products enough to sell them and/or to recruit other distributors, they can easily become distributors by signing up online to become part of the distributor network. I personally have sent some suggestions to Herbalife on how to make this change, and I am confident that Herbalife will be able to make those changes soon.
My conclusion is that Herbalife is not currently a pyramid or will ever be considered a pyramid here in the U.S. since per my best conservative guess, at least 60% to 75% of U.S. sales is to non-distributor customers. [(30% TO 35% "& growing" are direct sells to customers at clubs) + (20% of U.S. volume is shipped directly to non-distributor customers) + (traditional person-to-person sales to non-distributor customers) + (misclassified sales)] Also since an even higher percentage (40%) of global sales are from the fast growing direct sales clubs, I think we can reasonably conclude that sales of Herbalife's products outside of their worldwide distributorship network significantly exceed 50%.
Also with the significant amount of worldwide growth in club daily consumption sales of Herbalife products directly to non-distributer consumers, anyone trying to bring up an argument, that an Herbalife distributor can't make a profit selling Herbalife products, won't have much to hang their hat on. In fact, I think these clubs will be the growth engine that spurs Herbalife's growth to their goal of nearly tripling 2011's sales volume by the year 2020. Below are two quotes from Michael Johnson, with the first being from the 7/31/12 conference call previously linked above and the second from Herbalife's 2011 Annual Report, Johnson's letter to shareholders.
"As we continue to foster the transformation of our business, our distributors are leading the way through daily consumption, deeper city penetration, increased engagement, and they are living and wearing the brand in cities all over the world."
"In 2011, we reached, and exceeded, the aspirational goal set early in the company's history by founder Mark Hughes. Our new aspirational goal is to achieve 10 billion volume points by 2020. We believe we can achieve it…because we are just getting started."
If anyone is wondering whether Einhorn is currently or ever has been short or long Herbalife, so am I. The more time that passes by since Einhorn's May 1st lone appearance questioning Herbalife's management, the more people will figure out that Einhorn hasn't really ever come forward with anything negative about Herbalife, and the comment that he made on CNBC, "sometimes it's much ado about nothing" is really the only conclusion we can all come to about the markets reaction to Einhorn's questions on Herbalife's conference call.
The only question in my mind now is why Einhorn asked those questions on Herbalife's conference call when it didn't seem to match his pattern. He certainly could have posed those questions in a private conversation with Herbalife's management. Einhorn may have not been sure he really had enough information to attack Herbalife but thought by asking those questions publicly, he could at least get a reaction in the stock price, especially if he was already short Herbalife.
I think Einhorn has actually done Herbalife a great favor by examining its business operations in detail. Anyone who knows Einhorn's pattern should easily be able to conclude that if he would have found something significantly wrong with Herbalife's business, he would have came forward with his detailed findings by now. Einhorn is a very smart guy and wouldn't waste his time sitting in on a conference call for a company that he wasn't considering as to either shorting or going long its stock. Also, if you are waiting for Einhorn to come out publicly to give Herbalife's business a clean bill of health, don't hold your breath since he may still be short Herbalife.
Disclosure: I am long HLF.