Friday, December 7, 2012

The Risk of the Direct Selling Business Model


Herbalife (NYSE: HLF), after being a 10 bagger in more than 3 years, has plunged significantly after the famous hedge fund manager, David Einhorn, questioned the company in its earnings call in May. Because of his fame for short selling, the market might think Herbalife was one of his targets, and dampen its share price. To take advantage of the free fall, on Nov. 28, Richard Goudis, the company’s COO, stepped up and bought 45,516 shares at an average price of $43.89 per share, with the total transaction value of nearly $2 million. So at least one insider has been bullish about the company. Should we?
Network marketing is all about the in-house distributor network. I personally think that for this business model, the in-house distributors would actually be the main consumers of the products. In 2011, Herbalife reported to have around 2.7 million independent distributors in around 79 countries, and its main product is weight management, accounting for 62.5% of its total revenue. Avon Products (NYSE: AVP), which makes direct selling of the beauty products, had around 6.4 million independent representatives with sales operations in around 65 markets. Other peer, NuSkin (NYSE: NUS), with its anti-aging products, had around 850,000 active distributors in 52 countries globally. The business model seems to be intriguing, however, it has to rely on its distributors’ network for its sales. The risk is that if any distributor leaders leave the company, they would bring along their whole networks along with them. Thus the company would suddenly lose a great deal of its existing “internal consumers.” 
David Einhorn was showing his concern for the same issue as well. In the recent earnings call of Herbalife, he focused on three issues: the sales outside the network, the incentives between recruiting new distributors and selling the product for the markup, and the sales percentage between three groups of distributors.
On the first issue, Einhorn would like to know the sales level made outside the network and sales consumed within the distributor base. Rather than giving him the clear answer, Herbalife just generally said that it had a 70% custom rule, stating that 70% of products were sold for personal consumptions, either to consumers or to its own distributors. The company also said that it didn’t have the exact percentage of sales sold to non-distributor consumers. 
On the second issue, the supervisor will get a 50% discount if he buys the products directly. So if he sells products to consumers, he would make 50 points. If the consumer signs up with a distributor and buys the product himself directly from Herbalife, the supervisor would get the 25%.
The third issue raised by Einhorn was the company disclosed the percentage sales of three distributor groups but it didn’t repeat in the subsequent 10-K. Herbalife explained that the company took those percentages out of the 10-K due to a change in the CFO, noting further that the current CFO didn’t see it was a valuable information for both business and investors.
Indeed, the distributors are the real customers for the network marketing business model. If they are loyal, the business will benefit a whole lot. Valuation-wise, Herbalife seems to be quite cheap, at only 12x trailing earnings, or a 0.7x PEG ratio. However, it is quite comparable to its 5-year historical average valuation, of 12.9x P/E.  Herbalife is currently paying a 2.6% dividend yield. NuSkin is more expensive, with 14x P/E and a 0.9x PEG, but paying lower dividend yields of 1.7%. Avon is the one which pays the highest yield, about 5.4%, but it also the most expensive, with a 50.8x P/E and a 2.1x PEG.
Foolish Bottom Line
Herbalife seems to be cheap in terms of valuation. However, we do not know about the stickiness level of its distributor network. The more sticky the distributors, the higher value I would place on the company. However, since there's many unknowns surrounding this company, I would rather not place a bet at the moment. 

2 comments:

  1. Good info here about HLF. It will be interesting to watch.

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  2. Clearly a pyramid scheme. It is getting ridiculous in my area, it seems now everyone in my area either is in herbal life or knows someone that it is in herbal life. They keep pitching the same thing. "Get in now while there is still time" Umm no thanks...lol Herbal life might say "we are not a pyramid scheme" but how do you control 2.7 million people from using Herbal Life as a pyramid scheme? Very difficult...you can't control what people do to benefit themselves...especially 2.7 million people...Here is another fun fact...

    "About 1% of HerbaLife distributors make 85% of the company's gross sales. These distributors are in the upper echelons of the company, and were around back when the company was still starting up in the early 80's. The remaining 99% of HerbaLife distributors, who joined the company after the mid-1980's, make the remaining 15% of the company's gross sales."

    "What does that mean math-wise? Let's crunch the numbers: 99% of all reported HerbaLife distributors comes out to 1,782,000 distributors (99% of 1.8 million). Meanwhile, 15% of $3.5 billion comes out to $525 million. Divide $525 million by the 1,782,000 distributors and you obtain $294 in annual sales per distributor!! And keep in mind that is not profit, but sales, so the actual take-home pay is even less."

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