Herbalife: 5 Common Sense Arguments

| About: Herbalife Ltd. (HLF)
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I have written numerous articles arguing that Herbalife (NYSE:HLF) is a pyramid scheme. Many Seeking Alpha contributors have tried to analyze the data to either confirm or deny the idea that Herbalife is either a legitimate or an illegitimate business. Analysts have poured through court cases, financial models, etc. Sometimes the shortest distance between two points is common sense.

In this article, I would like to summarize my thesis and try to use basic common sense to articulate concisely why my analysis leads me to conclude that Herbalife is engaged in a pyramid scheme which is a form of "business opportunity" fraud. The answer lies in the way it misleads its distributors.

To begin, I think it is important to understand what business Herbalife is in, what its value proposition is, what its brand promise is.

Taken from the company's latest 10k, Herbalife states:

We are a global nutrition company founded in 1980 that sells weight management, healthy meals and snacks, sports and fitness, energy and targeted nutritional products as well as personal care products. Herbalife distributes and sells its products through a network of independent distributors, using the direct selling channel. As of December 31, 2012, we sold our products in 88 countries to and through a network of approximately 3.2 million independent distributors.

In my own words, Herbalife is a product company that rents its salesforce by recruiting independent entrepreneurs to sell product and then compensates them accordingly. In order for Herbalife to successfully recruit individual entrepreneurs to distribute product, the company must table and present a legitimate "business opportunity" to participants. Alternatively, the company must mislead recruits in order to secure their services.

I would like to argue that the question of whether or not Herbalife is a scheme or not boils down to the answers to these simple questions.

Does Herbalife need to deceive its new recruits to acquire their services or not? If a potential recruit was fully informed, would they sign-up? If a participant signs-up to pursue the Herbalife retail "business opportunity" can that individual make money or not?

Q. What does legitimate success look like?

Legitimate success in the context of a Herbalife distributorship is the ability to purchase products for a wholesale price, mark them up, and resell them for a retail profit to ultimate users of the product. This is the legitimacy that must be produced for the business to pass the Koscot test. William Keep and Peter Van Der Nat have tried to look at the generic MLM compensation scheme in aggregate to determine whether or not a given MLM company is a pyramid scheme. Bill Ackman has attempted to apply the Van Der Nat/Keep model to Herbalife. All of this research has stimulated robust debate.

In this article I would like to advance the idea that there is a more straightforward or direct way to conclude that Herbalife is a pyramid scheme. This direct way is to look at the experience of the distributor at an individual level.

Q. What is the likely business outcome for a new recruit who joins Herbalife today to pursue the retail "business opportunity"? I submit that if we can answer this question fairly and honestly, we can tell if Herbalife is a pyramid scheme or not.

The reason I am thoroughly convinced that Herbalife is a pyramid scheme is because the company's pricing and compensation policies make it virtually impossible for a Junior recruit to make any retail profit pursuing the "business opportunity". In practice, Herbalife's policies promote an endless chain. Evidence of market saturation is literally everywhere. As a result, the company is selling a retail "business opportunity" to new recruits that simply doesn't exist and is misleading new recruits to do so.

It is also my firm conclusion that a significant percentage of Herbalife's sales volume is the direct result of Inventory Loading, the up-front purchases of wholesale product made by new recruits to achieve advancement in the scheme.

In more aggressive language, the company recruits individuals to participate as partners in its business, gets them to "buy-in" by ordering product. Then, the company turns around and cuts these partners off at the knees with unfriendly policies and procedures.

I would like to point to 5 specific things that Herbalife does that leads me to that conclusion. These are 5 things that are directly in the company's control but serve to directly undermine its business partners.

1) Geographic Saturation - Herbalife does not offer its distributors any territorial protection, exclusivity nor territorial franchise rights whatsoever as it doles out distributor rights seemingly to anybody with a heartbeat and $59 to spare.

Specifically, retail market viability is an irrelevance to the company as it expands its distribution network ad nauseum. The company is unconcerned about the ratio of retail customers to distributors and does nothing to prevent saturation from occurring. This lack of control must inevitably lead to market saturation by geography. This inevitably means that the last participants to join the distribution network in a given territory are destined to lose money ceteris paribus. Geographic saturation is inevitable. Retail customers will prove elusive. Geographic saturation also makes Herbalife an endless chain.

Imagine, if you will, a McDonalds restaurant on all 4 corners of a busy intersection. What would we say to the franchisee for such a business? Would we say: "Boy, your business partners are treating you well!" or would we say "Boy, your franchisor is hosing you!"

Common sense leads me to conclude that too much competition can only be good for Herbalife and not the marginal recruit. The greater the number of distributors the worse the economic prospects for those same distributors.

2) Price Discrimination - As if an endless supply of distributorships weren't enough, Herbalife charges its new recruits 50% more for wholesale product than it charges its Sales Leaders. This deliberate price discrimination is likely an illegal anti-trust violation. Certainly, it encourages Inventory Loading. Certainly, it makes it impossible for Junior recruits to compete with Sales Leaders for actual retail customers in the end market. The actual retail price that real product transactions occur at guarantees economic losses for a Junior distributor were that distributor to retail at the same price. Herbalife's arguments that a new recruit can buy product for 25% off and retail it for SRP are a fiction.

The company knows for a fact that its Sales Leaders buy wholesale product for 50% off. The company also knows its Sales Leaders sell product routinely to end-users for 25% to 35% off. Yet still, the company misleads new recruits that legitimate retail opportunity exists at full SRP and continues to market a retail "business opportunity" to new recruits that doesn't really exist.

Common sense leads me to conclude that very little product may actually be sold at full SRP at all because no rational customer would pay full SRP.

3) Channel Conflict - as if price discrimination wasn't bad enough, Herbalife now tells us without apology that 73% of its distributors are simply "discount customers" purchasing product directly from the company at prices 25% - 50% off. This revelation is further evidence of market saturation. Instead of recruiting distributors as participants of the scheme, supposedly Sales leaders are left to recruit customers because no legitimate distributors are left to recruit. While this disclosure seems to be related to the company's desire to pass the Koscot test, the obvious implication of this unapologetic disclosure has to be: "Where on earth is the retail "business opportunity" then?"

The recently disclosed fact that the company now sells directly to end users must make it virtually impossible for anyone pursuing the "business opportunity" to find retail customers willing to pay full price. How is a new recruit supposed to compete against the company itself for retail sales if the company unabashedly is engaged in direct selling and at a lower price point?

It is easy for the company to say: "No big deal. Distributors with no downline are just customers", except for one thing. It's a huge deal! This revelation basically confirms that there simply is no legitimate retail "business opportunity" at all for a new distributor recruit trying to sell product at full SRP.

Common sense tells me that channel conflict can't be good for those chasing the "business opportunity".

4) Tariffs and Taxes- as if Direct Selling wasn't bad enough, Herbalife also imposes additional tariffs and duties that elevates the COGS for participants by 10% or more. This practice also makes the retail business unviable for a new recruit.

Common sense tells me the higher the cost of the product, the more difficult it would be to retail.

5) Misrepresentations - Most if not all of the marketing materials produced by the company and its distributors likely mislead potential participants as to their real probabilities of success in pursuit of the "business opportunity". Specifically, the company fails to disclose how its endless recruiting policies, discriminatory pricing policies and direct selling policies all conspire to undermine the new recruit's chances of ever succeeding as a retailer. The company also does not include the number of recruits who fail in its annual Statement of Average Gross Compensation. In fact, the company's Statement of Average Gross Compensation includes exactly zero information at all on how much money a distributor might make as a retailer. Rather, the entire disclosure is focused on recruiting rewards paid to upline participants.

Common sense tells me that if Herbalife gave its new recruits robust and complete information on the retail "business opportunity" including actual retail profits earned and churn rates, most distributors would never sign-up at all.

To summarize, the reason I am convinced Herbalife is an endless chain is because it seems obvious to me that the company is peddling a retail "business opportunity" that simply doesn't exist for a new recruit. While it may be true that an individual who was fortunate enough to get in early in the recruitment cycle can make some money, this is not evidence that a "business opportunity" misrepresentation does not exist. Nor is evidence of retail sales evidence that a "business opportunity" misrepresentation does not exist.

I would argue that the endless and relentless chain of recruiting activity to the inevitable point of market saturation is the common sense trump card that makes Herbalife a pyramid scheme. One must look at the entire scheme and not just select individuals to determine whether or not a pyramid scheme exists.

All evidence of actual business success in the business model accrues to participants above the Supervisor level. All evidence of failure in the scheme is directly connected to those at or below the Supervisor level. Specifically, the participants who churn out or fail at the enterprise are the most Junior participants year after year after year. Last year 1.5 million left, this year that number is likely to be higher.

Longs like to argue that the company has lots of customers and that the company moves lots of product and that there are lots of retail sales, etc.

My questions to each of you who advance that position are simply these:

What does any of this have to do with whether or not the company is a pyramid scheme or not? What does any of this have to do with whether or not new recruits can make any money? What does any of this have to do with whether or not the company treats its distributors fairly and honestly or not?

Q. How does Herbalife treat its new recruits?

The answer to this question is the central evidence that this company is a pyramid scheme. It is the central evidence of deception.

Herbalife is a pyramid scheme because as its business matures in each geography it penetrates it ends-up deceiving its new recruits by promising them the opportunity for success at a retail "business opportunity".

Then, the company immediately turns around and supports policies and procedures that make it absolutely impossible for that success to be achieved unless you happen to be lucky enough to have signed-up early in a geography or unless you are a Sales Leader or higher in the scheme.

End markets obviously get saturated, the company imposes no limits on saturation.

End retail prices obviously get discounted, the company imposes no limits on price discounting nor reveals to new recruits the actual likelihood that they will be able to sell product at SRP.

End users obviously get sold to directly, yet the company does nothing to prevent channel conflict.

The evidence of market saturation is everywhere.

Herbalife's policies and procedures helped the company move $4 billion of product last year by saturating 88 countries around the world. These policies and procedures also likely victimized as many as 1.5 million distributors in the process last year alone.

If I sign up today as a distributor, Herbalife's policies and procedures would conspire to transfer economic value from me as a new recruit who would make product purchases to finance inventory to participants up the line including shareholders. Herbalife's policies and procedures basically guarantee that I will lose as and when I go to retail product because there is no material mark-up to be had. Herbalife's compensation policies and procedures meanwhile reward those in the upline on my product purchases/Inventory Load whether I succeed or not as a retailer.

Herbalife markets a retail "business opportunity" that no longer exists, not for the last guy in, not for the late entrant, not for the marginal recruit.

Common sense analysis tells me that Herbalife is misleading its new recruits by recruiting them into saturated end markets. The building blocks for the deception are as obvious as the blue skies above:

  • Aggressive and Relentless Recruiting
  • Misrepresentations/Ommission of Key Details
  • Geographic Saturation
  • Wholesale Price Discrimination to encourage Inventory Loading
  • Aggressive Discounting off SRP by Senior Participants
  • Deliberate Direct Selling/Channel Conflict and
  • An 85% plus churn rate

Or if you prefer, a "business opportunity" that simply doesn't exist for the majority of the newest participants.

Common sense is the reason the FTC should intervene. Common sense is the reason the SEC should shut the endless chain of recruitment down.

If you want to know why Herbalife is a pyramid scheme all you have to do is zero-in on the obvious idea. All you have to do is reduce the argument to its simplest and most granular level. How does the company treat its newest distributors, its so-called business partners? 85% churn rates tell us the answer is "not well." Most lose money.

If you were to become a distributor today, what would happen to you and your money? Would you sign-up to retail Formula 1? What does common sense tell you?

The answer will guide you quickly to conclude whether or not Herbalife is a pyramid scheme (an endless chain) or not. Ackman has it right. The FTC and SEC regulators will quickly see it too. Icahn will ultimately figure it out when he asks the right question.

A pyramid scheme is a form of "business opportunity" misrepresentation. If you are selling a retail "business opportunity" to new recruits that doesn't really exist how do you argue that your business model is legit?

What does common sense tell you?

Disclosure: I am short HLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.