Herbalife: Can We Talk? Part Two

| About: Herbalife Ltd. (HLF)
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Does HLF's return policy negate "up-line-recruitment earnings" theory?

Where can unintentional inventory loading take place?

What does this mean to HLF?

In my previous article I put forth a premise that some MLMs could be presented with a real problem if up-line commissions were categorized as "recruitment fees".

In this article I would like to expand upon this premise with regards to the most common counter-argument and then try to see what conditions may have to be present for this premise to have a direct impact on Herbalife (NYSE:HLF).

The central premise was that all earnings paid to the up-line might be defined as "recruitment earnings" and only earnings related to the actual sale to the end-user would be "product related sales" unless they were "contingent" on end-user sales.

As would be expected, the premise brought forth some interesting comments, many worthy of further discussion. So, instead of re-hashing the original argument, I'm just going to look at a nuance.

Does a 100% return policy make a difference? The answer ... simply stated ... is a "qualified" YES.

A 100% return policy would lend credence to an argument that up-line earnings are linked to end-user sales, if they are "clawed-back".

However, that argument only has merit if, in operation, significantly all the unsold product is returned. In order to classify the return policy as a "contingency" it would have to actually work, not just have the possibility of working. There are at least a few obstacles:

1) Personal Consumption: Is all the product ostensibly purchased for personal consumption actually consumed? I don't know, but it would seem that it is critical to dispelling unreturned inventory. It would seem that some real detective and statistical work would be necessary to prove this one way or the other.

2) Ghost Transactions: Are participants buying some inventory to qualify for bigger discounts? Are they claiming sales to qualify for bonuses? Again, if this happens, then the return policy, though available, is not directly linked as would be required in a "contingency". Certainly this takes place at some level, but how much, requires even more detective work.

3) Under-reported sales: Participants pay taxes on net profits. This is reported on a Schedule C and filed with their 1040. The Schedule C includes items for gross sales and cost of goods (inventory).

Let's be honest, many small businesses that receive cash payments under-report receipts. Additionally, many small businesses that consume product themselves, improperly carry it as inventory to reduce their tax liability.

To the extent that HLF participants receive cash payments for merchandise and either under-report sales or inflate consumed inventory, it would present itself AS IF it were excess inventory.

Most importantly, these transactions are documented in tax filings and easily obtainable. One need only select a representative sample of Schedule C and determine if there is inventory "left over". Then it's a simple process to project. To counter this, participants would need to come forth and admit to filing a false tax return.

The FTC could put the participants between a rock and a hard place; are there unreturned inventories or are there perjured tax filings?

So, in summarizing the "return policy" argument, it is a good argument, but I think it can fall under its own weight.

Keep in mind, that for purposes of my articles, I raise these refund problems with context only to "contingent sales". It is possible that the FTC may take the Schedule C avenue in trying to apply it to "inventory loading". Just something to consider.

Moving ahead, each reader can take their own position as to whether or not up-line earnings, if not "contingent" are "recruitment" or "end-user". This is merely a premise I've put forth (one that I also contend is applicable).

We all have to wait to see whether or not it comes to pass. If the FTC goes after Herbalife, they will need to bring more than just the usual arguments. I wouldn't be surprised to see this premise surface.

But this brings me to my second contention. Is classifying all up-line earnings as "recruitment" a disaster for Herbalife?

Well, it would be if most of Herbalife's compensation was classified as "recruitment" and it would have no impact if most of Herbalife's compensation was "ultimate user product sales".

Unfortunately, much of the information needed to make an accurate assessment is not public (and may not even currently exist). That leaves me two choices:

1) Leave the issue hanging

2) Try my hand at detective work

Well, I choose to try my luck at detective work, so here goes.

According to the most recent Herbalife Financial Report, product sales by Herbalife to distributors (net, after the discount) were approximately $4 Billion (page 51, annual report). If all this product was consumed, the minimum profit to the Distributor or Supervisor would be somewhere between 25% and 50%.

I choose to take a conservative estimate at 25%, which means $1 Billion in direct sales earnings.

Let's now look at the total up-line earnings according to Herbalife's Compensation Chart for 2013.

According to this, there were 71,535 Supervisors (or above) that received, on average, $5,381 in up-line earnings. That comes to a grand total of Herbalife up-line payments of $385 Million.

Now, I know it is obscenely tilted towards the top 4%, but that's for another argument on another day.

But, I must stress, that this does not include retail or wholesale earnings made by the distributors, which, as stated earlier, could be as high as $1 Billion or more.

What I conclude from this very limited detective work is that total up-line, assuming it is all classified as "recruitment" represents only about 25% of total earnings.

This would seem to support a conclusion that the earnings are primarily resultant from "ultimate user sales".

However, this assumes that all the product sales are for someone's actual use and not inventory loading. As I stated earlier in this article, there is most certainly some amount of inventory loading from at least the three avenues I described.

But, by applying just a little math to the equation, we would find that in order for earnings to be primarily for "recruitment", inventory loading would have to account for about 60% of all product distributed.

If that were the case, then Herbalife would fail the Amway 70% test as well.

Conclusion: "Can We Talk" Part One and Part Two puts forth two concepts:

1) That all up-line earnings could (and I think SHOULD) be considered "recruitment earnings".

2) If that premised standard was applied to Herbalife, unless there was a majority of "inventory loading", Herbalife would still allocate its participants' earnings so that they could be said to primarily reward product sales over "recruitment".

Caveat: This exercise was dependent upon data supplied by Herbalife. Furthermore, this time I assumed, unlike in my Part One, that Supervisor wholesale earnings are not "recruitment".

I am not convinced that Supervisor wholesale earnings are free from a "recruitment" attack. But I have no data that would indicate what this amount is and then I'd have to break-out Retail Profit at 50%. Without data, it is an impossible task. Additionally, since about 90% of Supervisors don't receive much in royalties, it would support a thesis that most of their sales are "end-user" anyway.

Obtaining the Supervisor Wholesale data would be a very tedious task and it may well be too monumental a task for the FTC to undertake. As a result, disregarding it, though an acknowledged flaw in my analysis, may not be a fatal flaw.

So, this article reaches a very different result than my previous article in concluding that, unless inventory loading is extreme, it favors Herbalife sales as primarily "product related".

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.