Herbalife Chairman's Club member Humberto Jaimes lectures at his training center in Tecamac, Mexico, which is filled with enormous volumes of Herbalife products
Herbalife (NYSE:HLF) has long denied that its products pile up in distributors' garages. Yet in recent weeks we've learned that the company's products are being stockpiled in warehouses across Mexico.
Investors and regulators should have plenty of questions about this practice, particularly given that the company has gone out of its way to suggest that this type of activity had ceased in Mexico. It's only in recent months that the company began to disclose (though very selectively to a group of sympathetic analysts and investors) details about a practice it calls "field sales." The practice involves top distributors buying huge volumes of products from Herbalife, storing them in a network of warehouses across Mexico and then selling them to lower level distributors.
The business isn't supposed to work this way, and the fact that it does raises numerous red flags.
Framed as a Qualification Issue
The phrase "field sales" first emerged in a November 3, 2014 research report penned by Pivotal Research analyst and Herbalife shareholder Tim Ramey:
Starting February 2015 (volume month), field sales will NO longer be eligible toward Supervisor Qualifications. All Supervisor qualifying orders must be purchased directly from Herbalife (for both PPV & DLV). Field sales from a Supervisor to Member will not count toward Supervisor Qualification.
Barclays analyst Meredith Adler, whose firm has acted as an underwriter for Herbalife, also seemed to know, in advance, that the end of field sales was going to figure in the company's performance, though her expectations for the timing differed from Ramey's by a few months. Adler, as Ramey had done in his research report, put a positive spin on the discontinuation of field sales in her February 23, 2015 research report:
Starting on November 1, HLF eliminated the use of field sales in Mexico, meaning a distributor can only become a sales leader if he/she buys directly from HLF. As a result of this change, volume points were flat in 3Q14 after growing about 6% in 1H14. However, this change has long-term benefits, including ensuring sales leaders are properly trained and giving HLF better oversight of sales in Mexico.
During the company's first quarter conference call on February 28, CEO Michael Johnson told investors that a number of changes regarding distributor qualification, including the field sales crackdown, were weighing on sales in Mexico and would likely continue to be a drag on sales during the first quarter.
During the call, Herbalife took only a few questions and no one followed up on the field sales issue - at least publicly.
Mexico as a Role Model
That's surprising because what happens in Mexico is crucial to understanding Herbalife's broader business prospects. Under Johnson's tenure, Mexico has been touted as a roadmap for Herbalife's expansion around the world.
One of the company's oldest and largest markets, Mexico experienced a period of rapid growth following the introduction of the Nutrition Club model in about 2004. According to the company, Mexicans flock to Nutrition Clubs for good nutrition and a sense of belonging; for a few dollars a day, club members receive a Formula One shake, Aloe water and tea. Later, members may seek to open their own clubs, expanding the network of family and friends and neighbors who are exposed to the products and the business opportunity, ostensibly creating an endless cycle of expansion.
Herbalife had 37,000 nutrition clubs in Mexico at the end of 2013, making it far and away the leader in implementing this business method.
Source: Financial Times
Management has said that the success of Nutrition Clubs is proof that the company does not operate as a pyramid scheme. If you accept the company's statements at face value, products are not being stockpiled in distributors' garages; they are being consumed daily by customers in thousands of Nutrition Clubs, proof that Herbalife has real customers.
But it hasn't been all smooth sailing in Mexico.
Ethical Issues Arise
In January 2007, Herbalife held a conference call to announce that it was lowering guidance for Mexico. Management cited various compliance and logistics issues.
It seemed that the company's infrastructure in Mexico was insufficient to distribute the products beyond several urban centers. During a subsequent earnings call, Herbalife executive Richard Goudis explained that the compliance problem related to "illegitimate" distributors who had infiltrated Herbalife's ranks and were engaged in "non-compliant activities." These activities had been fueling Herbalife's growth. Goudis explained:
What was happening is, in markets or in states where we did not have distribution points, very entrepreneurial distributors were driving a pickup truck to a distribution center, picking up product and then selling to people that were not in their organization. (Bank of America Securities Consumer Conference, March 12, 2009)
Goudis's description sounds a lot like "field sales." The day after the January 2007 guidance adjustment, Herbalife's stock dropped 24%.
Creating a Vast Network
Herbalife supposedly had solved its compliance and logistics problems. The company terminated 10% of its Mexican distributors to get rid of the bad actors, and it set about creating more authorized locations at which distributors could purchase and pick up products. The company expanded its own network of warehouses from two locations in 2006 to twenty-one by 2009.
In Q1'2010 Herbalife partnered with Waldo's - a Mexican retailer - creating an arrangement that allowed distributors to pick up products at approximately 300 retail locations. Herbalife President Des Walsh explained how innovative distribution strategies were replacing the inappropriate practices of the past:
[I]n remote areas where it may take several days for product to reach them, and where it's not practical for them to have visited in person one of our 20 sales centers, what would happen in that area is that an upline distributor would effectively carry an inventory of product and they would actually sell that to their downline. … [Now] you've got the increased access with the additional Waldo's location that are causing those distributors to switch their patterns and buy directly from the company and pick up at a Waldo's. What that means is that distributor leaders who had a small warehouse who were supplying that inventory, effectively are selling off an inventory, because they no longer need to provide that service to their downline. - (Q1'2010 Earnings Call. May 4, 2010)
Agreements with other retailers followed. Ostensibly, the purpose of these additional locations was to help "alleviate congestion and improve distributor service levels," management said on a conference call on August 7, 2007. Importantly, the company's public disclosure would have you believe these are company-run distribution centers.
Except, it turns out, that wasn't the case. Not only had the field sales issue not been solved; it had become entrenched.
'Crappy Mexican Logistics'
On February 28, 2015, two days after Herbalife's quarterly conference call, John Hempton, an Australian investor and vocal Herbalife supporter, penned a blog entry touching on the issue. Like Ramey and Adler, he seemed to have more information than other shareholders as relates to field sales:
… in Mexico the up-line distributors have built warehouses all over the country - there are three Chairmans Club members who own the warehouses. The Chairmans club members can distribute Herbalife to you same day anywhere in the country almost everywhere - even with crappy Mexican logistics. [Emphasis added]
No mention of Waldo's? No mention of the company's warehouses? Instead, according to Hempton, several Chairman's Club members essentially took over the distribution of Herbalife's products in Mexico. In a March 9, 2015 report, research firm BTIG estimated field sales accounted for an incredible 70% of all sales in Mexico.
Why has Herbalife management played up the company's innovative Mexican distribution arrangements, such as Waldo's, if, in fact, the real solution had been to allow top distributors to run the logistics?
The scenario that Hempton describes raises more questions than it answers. How is it that a small group of top distributors have managed to create a logistics system that provides same-day delivery across Mexico? If that's what they are actually doing, then why is it necessary for Herbalife to create all these arrangements with Waldo's and others to help distribute the product? Why doesn't Herbalife simply use the system created by the top distributors rather than dismantle it?
Reallocating Volume Points
The whole system is just as perplexing from the distributor perspective. How were Mexican distributors qualifying for discounts and commissions if only those at the top were doing all of the buying from Herbalife?
To answer this question we asked a high-ranking distributor in Mexico to explain. The distributor told us that a few high-level distributors purchased the products from Herbalife and then filled out a form instructing Herbalife to reallocate credit for those purchases to lower level distributors. One benefit of the system is that it allowed top distributors to "help out" those beneath them while using their own purchases to earn commissions, he explained.
This isn't how the Herbalife compensation plan is supposed to work. A distributor is entitled to receive Royalty Override and Production Bonus payments from Herbalife when members of his or her downline organization purchase product from the company, but receiving such commissions on one's own purchases is not permitted under the plan. But that's what was happening in Mexico and it was happening on a huge scale.
To address the issue, Herbalife convened a meeting of Mexico President's Team members in Cancun this past January, and the group was lectured on the need to rein in this activity, according to the high-level distributor.
"Groups have implemented strategies that go against independent sales of Herbalife products," the distributor explained, adding: "Michael Johnson has reports about these discrepancies and anomalies."
The reallocation procedure might have started out as a way for top distributors to help finance purchases for cash-strapped downline members and to sell products to downline recruits who live far from official Herbalife distribution points, but it "got out of hand," according to the Mexico distributor. High-ranking Mexican distributors were buying huge volumes of product, warehousing the products and reallocating the volume en masse, he said.
The Problem with Field Sales
Why are field sales a problem? After all, if the system helps the company move its products in Mexico, what's wrong with that?
There are many problems:
1. Potential for Channel Stuffing / Earnings Manipulation: "Channel stuffing" is a manipulative accounting practice whereby a company accelerates revenue recognition and provides a near-term boost to its bottom line at the expense of future profitability, and as such is misleading to investors. In other words, more goods are shipped to distributors and retailers than consumers are expected to buy within a reasonable timeframe. The admission that Herbalife distributors operate a shadow network of warehouses across Mexico creates an environment of heightened risk for earnings manipulation. Given Herbalife's revenue recognition policy (Herbalife "recognizes revenue upon delivery and when both the title and risk and rewards pass to the member or importer," according to its 2014 10-K), the unique arrangement in Mexico creates risks that Herbalife may have accelerated its recognition of revenue by pushing huge amounts of inventory into the market. Unfortunately, investors have no way of knowing how much excess inventory is sitting in the channel in Mexico.
2. Off-Balance Sheet Cost Structure: Herbalife is failing to explain its real cost structure to investors and how top distributors personally bear the cost of warehousing and distribution. A few data points have previously surfaced which support this thesis, including: (1) Herbalife's surprising lack of operating leverage, (2) Herbalife's extraordinarily low shipping and handling expenses (link), and (3) stories of Herbalife distributors (at least, U.S. distributors) going bankrupt with million-dollar debts owed to shipping companies (link). The practice of pushing costs associated with transportation, warehousing, logistics, etc. onto distributors helps explain these phenomena. It also further exposes the fallacy of Herbalife's Statement of Average Gross Compensation which presents average distributor compensation before "expenses incurred by a Member in the operation or promotion of his or her business." Gross compensation is a meaningless statistic if you're spending hundreds of thousands of dollars to generate that compensation check.
3. Limited Auditor Visibility: Generally speaking, auditors have an obligation to "obtain sufficient appropriate audit evidence regarding the existence and condition of inventory," according to the American Institute of CPAs. Typically, auditors employ a physical inspection as part of their inventory audit. However, Herbalife's auditors would likely have limited visibility into inventory sitting in distributors' shadow warehouses. The Mexican field sales model generally creates an environment of heightened compliance and accounting risk.
4. Unquantified Shadow Inventory: Supporters of Herbalife have long disputed the charge that distributors pile up unsold inventory. We now have evidence from the company that an indeterminate - and very sizable - quantity of product is sitting in distributor warehouses all across Mexico. If BTIG's estimate is correct and that 70% of sales were until very recently done through field sales, the scale of this shadow inventory could still be huge. Ultimately, the magnitude and duration of Mexico's downturn will help analysts determine the quantity of inventory that is presently in distributor warehouses.
5. Compliance: Field sales would seem to violate important principles of Herbalife's Sales & Marketing Plan. Rule 18-C ("The 70% Rule") - fundamental to Herbalife's defense that it is not a pyramid scheme - requires distributors to certify that "at least 70% of the total value of Herbalife products a Distributor purchases each Volume Month must be sold or consumed that month." The practice of purchasing warehouses full of inventory for the purpose of subsequent resale is almost certainly in violation of rule 18-C. In fact, we've heard from sources that senior Mexican distributors are upset with the elimination of field sales because now they have to "actually retail" the product - that's a stunning admission given that company management consistently asserts that they are a product company and adamantly denies they are a promotional pyramid scheme that relies on recruiting.
6. Product Safety Risks: Herbalife product is perishable. The Sales & Marketing plan notes that product needs to be stored in a cool dry place, out of direct sunlight. The product also has a finite shelf life. The practice of Field Sales raises the risk that expired or spoiled product may be making its way to consumers across Mexico. We've heard from a source we deem reliable that distributors are selling expired product in Nutrition Clubs one cup at a time.
7. Distributor Favoritism: The entire concept of Field Sales reinforces a two-tier system of distributors - one that favors senior distributors who arrived in the pyramid scheme earlier to the disadvantage of junior distributors. Imagine having exclusive geographic distribution for Mexico and 79,000 captive Sales Leaders who are forced to purchase from you. Field sales would ensure that these Chairman's Club members are permanently affixed atop the Mexican pyramid.
More Questions Than Answers
Herbalife is planning to release first quarter 2015 financial results on May 5th. We expect that Mexico will be a big part of the explanation for poor performance in the quarter.
How big of an impact the elimination of field sales will play depends on how the practice fits into the Mexico business. Were field sales linked to some other incentive or qualification requirement? How many distributors will be cut off from the same-day delivery these Chairman's Club members were supposedly providing through their field sales arrangement? Was same-day delivery an important feature of the business?
For years, Herbalife has failed to disclose how its business really operates in one of its largest markets. In fact, the company has gone out of its way to present a misleading version of its Mexican business. Then, it only recently began to provide details - though selectively to Herbalife bulls, who have staked their reputations on the company not being a fraud.
By doing so, Herbalife has prevented investors from asking important questions:
How much product has backed up in these Mexican warehouses? How long will it take to unwind the inventory build up? How has Herbalife accounted for these bulk sales?
Have top distributors in Mexico been qualifying for advancement by selling product to recruits rather than retail customers? Are field sales tied to training programs, such as Club 100, that required distributors to consume product purchased by their upline in order to open their own Nutrition Clubs?
Why have top distributors in Mexico been willing to finance these large purchases and bear the cost of building out a same-day delivery system?
These questions encompass nearly every aspect of the business in Mexico and lead to one overarching question: What's really been going on in Mexico?
Disclosure: No positions
Additional Disclosure: Christine Richard is the President of Orion Research LLC, which does investigative research for investors. Pershing Square Capital Management, which has a short position on Herbalife and is a client of Orion Research LLC, provided input for this article.