Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Why Should You Care About What Happens To Herbalife (HLF)?

|Includes:Herbalife Ltd. (HLF)

Unless you've been living under a rock, you would have noticed that CNBC, CNN, and other financial news outlets have covered Herbalife to death since December 2012, when hedge fund manager Bill Ackman charged that the company is a pyramid scheme and has a target price of ZERO, essentially making a 1 billion dollar bet against the company. Since then, several other hedge fund managers have lined up both for and against the company.

But what does that have to do with you?

Today, I hope to address that question as either an investor, and as someone who may be looking to join Herbalife as a distributor. As it turns out, the answered are related.

Should You Care About Herbalife as an Investor?

Multiple authors from all over Wall Street and beyond have covered this topic... even Motley Fool. And the universal answer is pretty much "stay away". When hedge fund managers lined up on opposite sides of the issue of a company's future, armed with hundreds of millions of dollars, someone will end up the big loser, and risk is off the charts.

One guy said "This is a battle between Godzilla and Mothra in Tokyo, and you don't want to be in Tokyo". I agree 100% with his sentiment.

But say you want to understand what is the fundamental issue... it pins on one simple question... is Herbalife a Pyramid Scheme?

Should You Care about Herbalife as a potential recruit?

In this sour economy, people are looking for additional income and something like selling nutritional supplements like weight loss tea, nutritional shakes, and such sounds good, simple, and potentially profitable. But is it really?

And if it's NOT profitable, why would people join? That's what Bill Ackman pointed out... that Herbalife may have been selling "hopes and dreams" as the real profit maker, instead of the products like it was supposed to.

And of course, you would not want to join a pyramid scheme... since people in a pyramid scheme LOSE money, unless they recruit enough people to make them money instead.

So to answer both questions at the same time... it all boils down to one thing... Is Herbalife a Pyramid Scheme?

But to do that, we need to know what is a pyramid scheme.

What is a Pyramid Scheme?

Strangely, there is no legal definition of "pyramid scheme" in US Federal law. However, based on past cases, Grimes and Reese LLC, a lawfirm that specialize in MLM law, came up with the following 4 step test, which essentially summarizes the Koscot Interplanetary case (FTC vs. Koscot)

  1. Payment of money to the company;
  2. Participant receives right to sell product (or service);
  3. Participant receives compensation for recruiting others into the program;
  4. The compensation is unrelated to the sale of products (or services)

If the company has all four, it is an illegal pyramid.

A legal multi-level marketing firm would only have THREE out of the four, by basing compensation on the sales of product (or service), sold either directly by the participant or by participant's recruits.

Yes, MLM is ONE difference away from pyramid scheme. So, the question is, is Herbalife a pyramid scheme?

It's not that simple.

What is "self-consumption"?

By basing the compensation to the participant on sale of product (or service), MLM avoids being an illegal pyramid scheme. However, here's a fundamental problem... sale to who?

The idea of a "sale" is from one person (or entity) to ANOTHER person (or entity). In case of Herbalife, the idea is the distributor (participant) sell the Formula One shakes to people who want to buy them. However, this is rarely if ever done. Why? Because people are encouraged to JOIN Herbalife instead as a distributor, to get "25% discount", i.e. wholesale price. This was documented by CNN and other people who visited the nutrition clubs and asked various owners of such clubs.

In other words, these distributors are not selling to anyone, just to themselves. They buy it, they consume it. Self-consumption.

That causes a problem, because this seems to violate the fundamental nature of MLM... selling stuff. Indeed, there's a past case on this... Webster vs. Omnitrition, where the court ruled that you cannot sell the stuff to yourself in order to "fake" the sales and avoid the pyramid scheme classification. If a company had too much self-consumption, it is likely trying to fake its own position on the scale between MLM and pyramid scheme, by making participants load up on inventory (i.e. "inventory loading"), thus falsely claiming "sales" and legality.

Herbalife, in their January 2013 rebuttal, claimed that 73% of distributors do NOT expect to make a profit, thus implying that most of them just joined for the product discount, not for reselling and profit.

So how do you count product sold to them? As retail? Or wholesale? Is it self-consumption?

On the other hand, Herbalife has a liberal return policy and discourages "inventory loading", which is excessive inventory ordered by participants just to qualify for sales bonus. As they said, most of their distributors do NOT expect to make a profit.

Confusing, isn't it? What's worse, the company itself don't care about the answer.

Did Herbalife seek to distinguish itself from a pyramid scheme?

Modern pyramid schemes are often disguised with products, and in case of Herbalife, you can see that there is a significant "gray area" involving self-consumption. Herbalife discourages inventory loading, yet did not discourage self-consumption. It actively acknowledges that a significant number (72%) of their "distributors" don't distribute anything, but are self-consumers, in the January 2013 rebuttal.

In the May 2012 investor call, CEO and CFO of the company acknowledged that they don't know how many self-consumer, small retailer, and large retailer they actually have or how they came up with the criteria. They had included that in a previous year, and decided it is "not relevant" to the investor for 2012 so it's no longer included.

In other words, it knows it has a gray area, and it decided to do nothing about this gray area, and in fact, refused to acknowledge there's a gray area any more.

Is there another criteria we can use?

To determine whether Herbalife is a pyramid scheme or not, we need to go back to a more fundamental question, when the income is a mix between retail and recruiting. Do you make more from retail, or from recruiting? In other words, instead of a sharp line, we now have a percentage.

According to Herbalife, 40+% of their sales are now done through "nutrition clubs" (which was not even invented by Herbalife, but by one of their Mexican distributors, in 2003, according to CNN).

Do nutrition clubs sell a lot of retail? Absolutely. $5 will get you a tea, a shake, and some aloe drink. Do it every day. Steady business.

Do nutrition clubs make money for the owner, who's obviously an Herbalife distributor?

Uh... no.

Many such clubs have closed, as remarked by Bill Hempton. Further more, most clubs are barely getting by. CNN reports that one such place makes $3000 a month, but after expenses, income is nearly ZERO. The only exception? One guy who had 200+ recruits.

And all these recruits are distributors... for the 25% discount.

So retailing the stuff doesn't generate much profit.

But recruiting does.


Is Herbalife a pyramid scheme or a legitimate MLM?

Depends on how you look at it.

If you accept that Herbalife's compensation plan rewards its distributors more for recruiting other distributors ("I join for the discount") than to sell retail, you're probably thinking more toward "pyramid scheme".

If on the other hand, you accept that "self-consumption" is valid "retail" and thus recruiting self-consumers is still retail, then you're probably thinking more toward "legitimate MLM".

Should you care about Herbalife as an Investor?

Yes, as this will likely determine the future of all MLMs and legality of "self-consumption".

Should you care about Herbalife as a potential recruit?

Yes... stay away from the company that admits 72% of its "distributors" do NOT expect to make money. This company admits so. Most company will NOT be so honest.

Either way, I hope you have learned something.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Stocks: HLF