Login

Log In

Enter your username and password below

Don’t Let a Mediocre Yield Pull You into This Scheme

Herbalife (NYSE: HLF) reported excellent earnings yesterday, beating estimates with sales up 17% from last quarter. And it has a not-too-shabby dividend yield of 2.7%, which might make you all the more interested…

Well, not so fast.

As Louis Basenese pointed out at Wall Street Daily: “It’s only a matter of time before the rest of the world wises up to the true nature” of businesses like Herbalife. And given the general investment optimism surrounding the company (Jim Cramer is a long-standing fan), Lou’s criticisms are in need of a reboot.

First, a brief history lesson…

David Einhorn, the much vaunted hedge fund manager, jumped on an Herbalife earnings call last May, and inquired about the core of its business model. In spirit, the questions he asked can be summed up quite simply: Is Herbalife a pyramid scheme?

The answers to the questions were evasive, investors got spooked (thinking Einhorn was about to short the stock) and HLF dove about 20%.

Herbalife’s stock still hasn’t recovered from the Einhorn debacle. (It’s down about 4%, even after yesterday’s estimate-beating earnings call.) And the company hasn’t put to rest the concerns he raised, either.

So is Herbalife a Pyramid Scheme?

The criticisms keep on coming that at its core the business is an elaborate pyramid scheme, incentivizing recruitment and in-network sales over the sale of its products to actual customers.

There was enough compelling evidence that this is the case that Belgian courts ruled Herbalife isn’t the “multi-level marketing company” (MLM) it claims to be, but an out-and-out pyramid scheme. As such, it is no longer allowed to carry out business in the country.

The crux of the court’s ruling is based on “duplication” or recruiting.  As Herbalife CEO, Michael Johnson, explains, “They said that we were recruiting and paying for recruiting – we don’t do that.”

Well, that’s partially true, at least…

While there isn’t any direct compensation for recruitment, there’s indirect compensation through increased product discounts. The incentive for distributors to recruit more distributors is that a larger network means more sales and higher discounts for bulk product purchases.

In fact, Herbalife stresses recruitment as a primary avenue for profit in its own handbook:

“A second way of profits at Herbalife is the recruiting or duplication of persons. This is at first sight an under estimated system of financial gain, but in fact maybe even more important than the profit on the direct sale.”

What’s the problem? Products are getting sold to someone, even if it’s just other distributors. Why is this talk about recruitment versus direct sale to customers so worrying?

If simply moving products further on down through a network of distributors makes sales, the product has no real market. It either keeps on circulating as the network grows through “duplication” or it ends in a stockpile in someone’s garage.

As, David Vladeck, Head of Consumer Protection at the FTC explains:

“In order for an MLM to differentiate itself from a pyramid scheme, it has to show that it’s actually selling a real product to real consumers. And if your answer is ‘we don’t know’ – that’s a red flag.”

Herbalife at least acknowledges the need for such sales. They have a 70% rule which suggests “that 70% of all products is sold to consumers or actually consumed by distributors for their own personal use.”

But that rule’s neither monitored nor enforced, because as Desmond Walsh pointed out to Einhorn, “we don’t have visibility to that level of detail.”

In other words, the company really can’t say how much of its product is sold to real consumers. Herbalife doesn’t know its own business and neither do we.

Pyramid Scheme or No, There’s Another Problem…

But even if we give Herbalife the benefit of the doubt that it just has sub-par accounting practices, the picture still doesn’t look good.

Why? It would mean Herbalife really is the multi-level marketing company it claims to be! But as it turns out, MLMs have a pretty rotten problem too.

Robert Fitzpatrick, a court-recognized expert on MLMs, found that “MLMs sustain their operations by annually churning 60% to 90% of all participants who quit the schemes and stop purchasing the MLM products after suffering financial losses.”

This “churn” problem is precisely in line with what the Belgian court determined in its ruling:

“Herbalife is getting the biggest part of [its] profit out of the distributors who don’t make a high monthly turnover and who most likely resign after less than a year.”

Worse still, the problem takes a great deal of time to materialize. As Fitzpatrick points out, the company “can operate for years only from the investments of salespeople without any retail sales at all.”

Herbalife, to stay above board, is continually entering emerging markets. But this can only last for so long. Eventually it’ll have suckered in all available willing distributors, which will be a bad day for the stockholders currently so bullish on the company.

Bottom line: Whether Herbalife is a pyramid scheme or an MLM doesn’t make the slightest bit of difference for the long-term investor. Either way it’s running on the gases of an inferior business model based entirely on churn.  And that won’t end well.

Best regards,

Ryan Anders.