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

Why I Am Shorting Herbalife And Why You Should Too

|Includes: Herbalife Ltd. (HLF)

There has been a lot of speculation regarding Herbalife (NYSE:HLF). Longs have touted Herbalife's excellent valuation compared to the industry. Shorts have proposed that Herbalife is a pyramid scheme and normal valuations do not apply given Herbalife's troubled future. The big question that remains: is Herbalife a pyramid scheme?

The SEC lays out seven hallmarks of pyramid schemes. In this article I will go through each of these hallmarks and relate them to Herbalife.

The seven hallmarks:

· No genuine product or service. MLM programs involve selling a genuine product or service to people who are not in the program. Exercise caution if there is no underlying product or service being sold to others, or if what is being sold is speculative or appears inappropriately priced.

· Promises of high returns in a short time period. Be leery of pitches for exponential returns and "get rich quick" claims. High returns and fast cash in an MLM program may suggest that commissions are being paid out of money from new recruits rather than revenue generated by product sales.

· Easy money or passive income. Be wary if you are offered compensation in exchange for little work such as making payments, recruiting others, and placing advertisements.

· No demonstrated revenue from retail sales. Ask to see documents, such as financial statements audited by a certified public accountant (NYSE:CPA), showing that the MLM company generates revenue from selling its products or services to people outside the program.

· Buy-in required. The goal of an MLM program is to sell products. Be careful if you are required to pay a buy-in to participate in the program, even if the buy-in is a nominal one-time or recurring fee (e.g., $10 or $10/month).

· Complex commission structure. Be concerned unless commissions are based on products or services that you or your recruits sell to people outside the program. If you do not understand how you will be compensated, be cautious.

· Emphasis on recruiting. If a program primarily focuses on recruiting others to join the program for a fee, it is likely a pyramid scheme. Be skeptical if you will receive more compensation for recruiting others than for product sales.

Source:http://www.sec.gov/investor/alerts/ia_pyramid.htm#.U5MzP5SwKZa

· No genuine product or service. MLM programs involve selling a genuine product or service to people who are not in the program. Exercise caution if there is no underlying product or service being sold to others, or if what is being sold is speculative or appears inappropriately priced.

This is the most difficult hallmark to prove. Herbalife does have real products Formula 1, Herbal Tea, Niteworks etc.… The problem with all of these products is that they are all well overpriced relative to competitors. Pershing Square best illustrated this with Formula 1:

Source: http://www.factsaboutherbalife.com/media/2013/01/Who-wants-to-be-a-Millionaire.pdf (Pershing Square's "Who Wants to be a Millionaire?" slide 16)

The premium price is common among all Herbalife products. Herbalife's main products are 2 times as expensive their competitors. Because there is nothing proprietary about Herbalife's products, the end demand for them is small.

· Promises of high returns in a short time period. Be leery of pitches for exponential returns and "get rich quick" claims. High returns and fast cash in an MLM program may suggest that commissions are being paid out of money from new recruits rather than revenue generated by product sales.

Herbalife has taken down many of their outrageous testimonials off their websites, but many of these testimonials still exist online.

Jim Rohn: "Within less than six months [as a distributor] I was making more money part time than I was making on my full time job."

Source: http://youtu.be/XLmFzaKs4aM?t=9m4s

"[By] our second year or income hit a million one ($1.1 million)"

Source: http://www.pscmhlflibrary.com/profile-of-an-herbalife-chairmans-club-member/ (2:20)

Easy money or passive income. Be wary if you are offered compensation in exchange for little work such as making payments, recruiting others, and placing advertisements.

Herbalife recruitment video:

"This is a chance of a lifetime. Where else do you know where you can go and be able to create a business that will allow you to develop passive residual income?"

http://www.factsaboutherbalife.com/its-a-chance-of-the-lifetime/(About the 5 minute mark)

Herbalife's Recruitment slide:

Source: http://www.factsaboutherbalife.com/media/2013/01/Who-wants-to-be-a-Millionaire.pdf (slide 55)

From the slide above, it is clear that Herbalife promises growth in passive income. Income "when you don't work yourself" is considered passive income.

· No demonstrated revenue from retail sales. Ask to see documents, such as financial statements audited by a certified public accountant , showing that the MLM company generates revenue from selling its products or services to people outside the program.

This is also fairly difficult to prove. Herbalife pays out royalties for how much inventory a distributor buys, not how much he or she sells. Distributors are often motivated to buy inventory in order to become a supervisor. Supervisors receive royalties from their "down line", people they recruit, recruits of their recruits … In order to reach the rank of supervisor many distributors will buy inventory without customers. With this excess inventory distributors often sellproduct for below market prices via Amazon or to other distributors. Herbalife is troubled in proving that their products have end consumers. They say they do track this data, but do not want to release it to the public in order to ensure distributor-customer privacy. The reality is Herbalife makes money from selling product to distributors, not end users. For example, Formula 1 has outsold (to distributors) Slimfast, Lean Shake, and Ensure combined. Despite this, Formula 1 is unknown to the general public. Have you ever seen Formula 1 product, in person?

· Buy-in required. The goal of an MLM program is to sell products. Be careful if you are required to pay a buy-in to participate in the program, even if the buy-in is a nominal one-time or recurring fee (e.g., $10 or $10/month).

In order to sell Herbalife products, distributors are required to pay between $60-$100 for a start up pack.

Source: http://opportunity.herbalife.com/

· Complex commission structure. Be concerned unless commissions are based on products or services that you or your recruits sell to people outside the program. If you do not understand how you will be compensated, be cautious.

The "Sales & Marketing Plan and Business Rules" is over 100 pages long, with roughly 50 pages describing the compensation structure. In general, if it takes 50 pages to explain something, then it is complicated.

One of the hundreds of rules laid out in Herbalife's business pamphlet is rule 26-F (on page 81), which reads as follows:

Distributors must immediately discontinue email activity if they receive any inquiry or notice of action from a governmental authority regarding their email practices. Distributors must report all such notices or inquiries immediately to Herbalife's World Operations Home Office.Herbalife retains the option to suspend, terminate and take other disciplinary or legal action against any Distributorship that is not in compliance with Herbalife's Rules and the laws. This is in addition to Herbalife's other rights and remedies.

Link to Handbook:http://factsaboutherbalife.com/media/2012/12/Marketing-Plan-and-Business-Rules-2012.pdf (page 81)

This seems odd by nature. Herbalife requires all its distributors to immediately shut down their emails and contact Herbalife in any inquiry by the government. This seems like Herbalife is preemptively expecting government inquiries, possibly because they are a pyramid scheme.

· Emphasis on recruiting. If a program primarily focuses on recruiting others to join the program for a fee, it is likely a pyramid scheme. Be skeptical if you will receive more compensation for recruiting others than for product sales.

As mentioned before, all Herbalife distributors are required to pay between $60-$100 when joining the company.

From Herbalife distributor meeting:

"If you are recruiting and your check is not moving up, you need to look at what you are considering recruiting… You want to move your check? …. My point is this: you need to find those people who are looking for opportunity."

"This is the time to recruit … There has never been a time this easy."

Link to video: http://www.factsaboutherbalife.com/susan-peterson-founders-circle-member-profile/

This article touches on the basic flaws with Herbalife. The SEC laid out specific metrics that are expected in a pyramid scheme and Herbalife fits the bill. With all the controversy, it is useful to sit back and look at the facts. In the words on Benjamin Graham, "The individual investor should act consistently as an investor and not as a speculator."

Disclosure: I am short HLF.

Additional disclosure: I own puts on Herbalife which expire in January 2015.