After a Herbalife (HLF) conference call it is always necessary to do some fact checking and parsing. We have seen some audacious claims under Johnson, but my initial view is that things are even worse under the Goudis regime. Of course Goudis has a much bigger problem to cover up now the FTC requirements are in place and new reporting numbers are providing greater insight than ever before.
This article identifies a number of very significant falsehoods, misdirection's and contradictions regarding North America that came out in the Q3 earnings call. Even those skeptical of the short argument will not be able to explain away these inconvenient findings. All quotes are from the Herbalife Q3 earnings report unless otherwise stated. All discussion pertains to the North American market whether explicitly stated or not.
Before I begin let me introduce the reader to a few abbreviations and definitions.
- VP's - Volume Points, an Herbalife measure of sales.
- Sales Leader - A distributor with sales of 4,000+ VP's in a 12-month period.
- SAGC - Statement of Average Gross Compensation, an annual Herbalife disclosure to potential members.
- QBKM - Quarterly Breakout Key Metrics, supplementary data published quarterly.
Let's get started.
Issue 1 - North American Distributor Growth
This was a doozy. During the call both John DeSimone (CFO) and Des Walsh (President) claimed that new distributor growth in North America was 9%.
"As discussed last quarter, the US has implemented programs to encourage activity and we are beginning to see some benefits as evidenced by 9% sequential increase in new distributors compared to Q2." John DeSimone.
"So we saw the impact of that in Q3, right. We've reported 9% increase in your distributors in Q3 compared to Q2. The significant double-digit increase in terms of sponsors increased level of engagement." Des Walsh
Let's take a look at the real number. Each quarter the company publishes its Quarterly Breakout Key Metrics (QBKM) which contain information like Volume Points, New Distributors etc. as shown below.
The type is a little small so the key figures that relate to this claim are in the last two vertical columns in white for Q2 and Q3.
- New Members in Q2 (distributors): 12,015
- New Members in Q3 (distributors): 12,440
- The Q3 differential is +425 distributors. 425 as a percentage of 12,015 is 3.5%.
Herbalife exaggerated their distributor growth in the US by 257%. Intentional lie or accident? I'll let the reader decide that for themselves.
Issue 2: Herbalife Claims 47.4% Member Growth in North America
In the call we got a rare insight into Herbalife's total member count in a comment made by Des Walsh (incorrectly attributed to John DeSimone in the transcript) during the question and answer portion of the call.
"In terms of the balance, today, we've got about 470,000 preferred members, we've got about roughly 215,000 distributors. So it's roughly a sort of a 2/3rd, 1/3 ratio. That we've always believed, as you know, historically that we had roughly that number of people coming into the business, primarily for discount on the products" - Des Walsh (President)
This total of 685,000 members (Distributors & Preferred) is a huge increase over past numbers and yet it passed as a casual comment. In the 2016 SAGC published on 4/17/2017, the computed membership numbers are 464,736 .
These new numbers therefore reflect combined member growth of 47.4% in North America since 2016. How can member growth of nearly 50% possibly result in a Volume Point decrease of 17%?
The answer is quite simple. Most of these Preferred Members were acquired merely to boost the numbers and sustain the Herbalife mythology, but in reality, contribute nothing to sales. You can read "How Herbalife Fooled Wall Street With Its Preferred Member Numbers" for more information on this big deception.
Issue 3: The Split of Distributors to Preferred Members
The ratio of distributors to "discount only members" has been one that has been widely discussed in the past and the company has been very careful not to disclose specific numbers, until now. As you previously read, Herbalife now claims the split is 2/3 Preferred Members and 1/3 Distributors.
As we discussed in Issue 2, total membership in North America has jumped from 464,736 in 2016 to 685,000 as of Q3 2017. We know that distributor numbers are down in the US since the implementation of the FTC order, so this huge jump of at least 220,000 in total membership can only be accounted for by a highly suspect and sudden increase in Preferred Members.
If we back out the suspect 220,000 Preferred Members from the 470,000 total, we are left with 250,000 Preferred Members that are possibly legitimate. The true ratio of Distributors to Preferred Members is therefore much closer to 215,000 / 250,000, a split of 46% distributors and 54% Preferred Members. Even that I believe to be quite generous.
Issue 4: North America Business is now Stable
The key indicator for North America was whether the decline witnessed in Q2 would worsen, stabilize or improve in Q3. With Volume Points -16.1% vs. -18.5% in Q2 and new distributors up 9% (really 3.5%) they deemed the situation in North America to be stable.
"Importantly after our North American business adjusted to the changes implemented earlier this year, our business has been stable, and we believe we will now build off this new base." -Rich Goudis (CEO)
"So, the base is stable, starting to grow and the comps are getting easier." - John DeSimone (CFO)
Management is painting a picture that things are turning around in North America, but is that really the case?
One of the numbers published each quarter in the QBKM is the Average Sales Leaders with VP, sometimes referred to as Average Active Sales Leaders. Herbalife deems this number so important that it is included in their annual report and is considered "an indication of the success of our strategies and execution".
[Source: Herbalife 2015 Annual Report - Page 45]
Got it? Average Sales Leaders with VP is simply a measure of how many of their Sales Leaders have sold product in a given period, in this case a quarter.
It's a bit of an eye chart so here are the important numbers. In Q2 the Y/Y Average Sales Leaders with VP decreased from 77,596 to 55,542, a decrease of 28.4%. In Q3 the numbers went from 81,035 to 53,584, a YoY decrease of 33.9%. This key metric has not stabilized, but declined a further 5.5% in Q3.
While Herbalife chooses to use the word stable it should be noted that this "stability" comes as a result of an unprecedented recruitment effort in North America (See Appendix 3), coupled with incentives that were significant enough for Rich Goudis to call this out in the Q2 earnings call.
"And couple of things to keep in mind for Q3. One is there is a meaningful amount of expenses that were projected in Q2 that have been moved mostly into Q3, and that's around marketing and promotions."
The new normal requires higher costs for new distributor acquisition and lower distributor engagement under the FTC requirements.
Issue 5: The Big Change Contradiction
The company makes a great deal of noise over the future adoption of SalesForce, a Customer Relationship Management (CRM) platform, in North America during 2018. The fanfare implies that this change will increase engagement and sales in the future.
Does anyone recall Rich Goudis' explanation for the drop in VP for North America back in Q2?
"the short-term volume softness we experienced this past quarter is typical when our distributors shift their attention from building their businesses to a temporary acute focus on learning new tools and procedures, and business techniques." - Rich Goudis (CEO)
Quite the contradiction? If a change in how distributors did things in 2017 created a permanent 16%-18% drop in sales, how can a similarly substantial change in 2018 have no negative effect on sales whatsoever. In fact it is supposed to boost sales.
Issue 6: Distributor Attrition Exceeds Recruitment
As we now know, Herbalife has 215,000 distributors of which 64,094 are Sales Leaders. Each year in the Annual Report, Herbalife identifies the retention rate of Sales Leaders in each geography.
[Source: Herbalife 2016 Annual Report - Page 50]
Sales Leaders are defined as those that achieve 4,000+ VP in sales during a consecutive 12-month period. Among this select group the retention rate was 58.3% in North America during 2016, or a dropout rate of 41.7%. It would therefore seem reasonable to expect the dropout rate to be even higher among the general distributor population where the sales volumes are lower.
But, even if we are generous and assume the same dropout rate across all distributors, we would expect to lose 89,655 distributors (41.7% of 215,000) annually or 22,400 per quarter. Compare this dropout rate to the recent quarterly distributor recruitment rate of 12,000 per quarter and the problem becomes obvious.
For every ten distributors that leave Herbalife less than 6 new distributors are taking their place. This is an unsustainable situation that Herbalife must desperately try and correct.
Issue 7: Return to Growth
The return to growth in North America is a big concern and is an indicator of the impact the FTC order has on the business. In the Q2 earnings call Des Walsh gave this response to a question from Beth Kite regarding the new promotions in North America.
"So that was extremely well received by our distributor dealership and we think that's going to be one of those things that you're going to see have an impact in the latter half of this year." Des Walsh (President)
Now in Q3 the company's statement on the North American market recovering was this:
"We currently expect to see volume growth in North America in Q2, 2018 once we annualized the changes made earlier this year." - John DeSimone (CFO)
Basically, Herbalife is saying wait until 4 quarters of post FTC impact have passed and then the year over year numbers will start to look better.
However, back in Q2 Rich Goudis set this expectation with regards to FTC impact:
"As those of you who have followed us for a while know, we have gone through similar transitions in recent years and the short-term volume softness we experienced this past quarter is typical when our distributors shift their attention from building their businesses to a temporary acute focus on learning new tools and procedures, and business techniques."
The key phrase here is "short-term". Now the company has completely reversed themselves and is saying that the big drop in North America volume points is now permanent.
The big drop in North America Volume Points isn't "short-term" and never was. The plan is simply to limit the slide of the US market as much as possible so that it can potentially be explained away by other factors.
With US members now divided into Distributors and Preferred Members, Herbalife can no longer obfuscate the numbers to the degree they once could. As we get more information, the magnitude of past deceptions becomes apparent and many pre and post FTC statements become irreconcilable. Even those who might not have questioned Herbalife in the past must realize that the old "truths" bear little resemblance to what we now know to be fact.
Wake up analysts!!! Surely there is one of you willing to do more than take Herbalife statements at face value.
Disclosure: I am/we are 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.