Herbalife (NYSE: HLF) has been hit by a short seller again. Earlier this year it was David Einhorn simply asking questions about the business. This time it is Bill Ackman calling Herbalife a pyramid scheme and laying out his case.
Pyramid scheme allegations are nothing new. Each time, Herbalife vehemently denies it is a pyramid scheme, and says it’s a legitimate company, with legitimate products, and a legitimate business opportunity. It is this “business opportunity” that merits the pyramid scheme allegations.
Herb Greenberg of CNBC has been researching Herbalife for a long time. Back in May, Greeberg pointed out the reasons he thinks investors should worry about Herbalife:
- While Herbalife says it does a ton of research and development, its actual spending on R&D is very low
- This business model relies on recruiting new people into the opportunity
- Herbalife has no idea how much of the product actually ends up in the hands of third-party consumers, rather than just the HLF distributors
- The company points out in its 10-Ks that there are regulatory concerns that could harm it (so while MLMs are generally allowed to operate in the U.S. and have been given some legitimacy, that could change)
- Herbalife mentions “retail sales” over and over in its SEC filings, yet (as mentioned above), it has no idea how much of the product is actually retailed to third parties
- In Belgium, Herbalife has been deemed a pyramid scheme
- The company admits it has a high turnover rate among distributors. (Although the company stopped releasing the actual figures, as recently as 2005 Herbalife reported a 90% turnover rate among non-supervisors.)
What does Bill Ackman have to say about Herbalife? In a presentation today by Ackman and Shane Dinneen at the Ira Sohn Conference, the following issues were highlighted:
- While the company’s mission is providing good weight loss products, only one guy in the crowd had ever purchased the products
- So many people have never heard of Herbalife’s Formula 1 product (the most popular), but have heard of competitors’ products
- How can Herbalife sell six times more nutrition powder than companies like Abbot Labs and Unilever?
- Pricing? No. Herbalife is 3 times higher.
- Proprietary products? No. They’re commodities and comparable to other products.
- Advertising spending? No. A tiny amount is spent by HLF on advertising.
- Innovation? No. The company donates a small amount ($1.5 million in 2011) to the UCLA Research Lab, an affiliation that Herbalife trumpets as important. Yet it paid spokesman Dr. Louis Ignarro and his consulting firm $15 to promote the products (not to do R&D).
- Pyramid schemes feature people making money at the top because of losses by people at the bottom. The money at the top is only there because people at the bottom are losing. Herbalife participants make their money from recruitment, not from the sale of products.
- The suggested retail price of HLF products is inflated.
- Dinneen believes the 70% rule (requiring distributors to sell or consume 70% of the products they purchase from Herbalife) is NOT enforced.
- Herbalife does not track retail sales outside of the distributor network, but Dinneen believes it could.
- Ackman and Dinneen believe that the “discount buyers” trumpeted by HLF are NOT people who signed up to receive a discount on Herbalife products. They are really just failed distributors.
- Herbalife’s accounting is misleading: Wholesale commissions are not retail profit, but HLF calls it retail profit. (Retail profit SHOULD be profits on sales to customers, not on sales to other distributors.)
- Ackman and Dinneen believe the average retail profit is $5 a month.
- Ackman says he thinks the typical Herbalife distributor earns less than $10 per month in retail profit.
- After David Einhorn asked questions, HLF changed its disclosures.
- Herbalife’s disclosure on distributor earnings leaves off 93% of the distributors. The 93% aren’t making any money.
- Distributors are unlikely to get to the top of the pyramid. Anyone can’t do it, even though people are recruited by being led to believe they can.
- Recruint is achieved by exploiting people “vulnerable to the dream” (minorities, college students, at-home moms)
- The compensation rules are extremely complex
- Growth has been fueled by entering new markets overseas, with something referred to as “pop and drop” (which appears to a process including entering a new country, getting a spike in activity, presenting the data, and then not presenting the data for that country separately again after the numbers drop off)
- Herbalife is running out of countries to enter. A weight loss product being marketed in Ghana????
- Ackman’s research on the Herbalife Clubs shows a much different picture than the one presented by HLF. The clubs look rundown and don’t have Herbalife signs up.
- Shipping and handling charges represent 15% of sales figures. $339 million in profits comes from shipping charges.
- Herbalife touts only 0.4% of products being returned by distributors. Ackman says that’s not because retail sales have occurred, but because it’s painful to return the products. Commissions already paid are deducted out of the money the distributor receives back.
- The insiders are making the real money, as evidenced by CEO Michael Johnson’s $140 million of HLF stock sales since 2007 and his $89.4 million salary in 2011.
None of this information is really new. But it is right on point. Take a careful look at Herbalife’s most recent 10-K filed with the SEC. What is most interesting is what is NOT disclosed. The company takes great pains to provide lots of little numbers. That means they have disclosed a lot. Right?
Wrong. There are key pieces of information that are not disclosed, which make it virtually impossible for an analyst to fully understand the business of recruiting in the pyramid. Here are a few simple questions that could shed more light on the “business opportunity”:
- 2.7 million distributors are highlighted in the most recent 10-K. At what point in time is this for? How was the number calculated?
- How many new distributors were recruited in 2011 and 2012?
- How do you define “active” distributors? How many distributors were active at the end of 2011 and 2012?
- How many non-terminated distributors were there at the end of 2011 and 2012?
- 548,000 sales leaders were mentioned in the most recent 10-K. At what point in time is this for? How was the number calculated?
- How many distributors became new sales leaders during 2011 and 2012?
- How do you define “average active sales leaders” and how many were there at the end of 2011 and 2012?
- What was the average monthly retail purchase per distributor in 2011 and 2012?
- What was the average monthly retail purchase per sales leader in 2011 and 2012?
- What were the total retail purchases by sales leaders in 2011 and 2012?
- What were the total retail purchases by non-sales leaders in 2011 and 2012?
- The 2011 10-K cites 548,000 sales leaders at 12/31/11, but shows only 318,000 at 2/28/11. Were 230,000 new sales leaders added in 10 months? If so, that equals 23,000 per month when only 29,000 sales leaders were added in January and February 2011 (or 14,500 per month). Please explain the discrepancy.
- Why did you stop disclosing the turnover rate for distributors after 2005?
More to come, I’m sure.