This is the third article in the 3-article series to recoup Bill Ackman’s analysis on one of his highest conviction investments he has ever made, shorting Herbalife (NYSE: HLF). In the previous articles, Ackman has pointed out the irrationality of Herbalife for its 30+ year extremely high growth and the significant volume even with a much higher price than other peers. He also mentioned four adjustments needed to be made to truly reflect Herbalife’s business models in terms of, retail price, internal consumption, retail profits and recruiting rewards. This article will summarize Ackman’s analysis on the company’s statements about supervisor’s compensation, the real “success” of Herbalife’s distributors and several other red flags.
The question of why the company sold many commodity products without advertisement, at the very high price, has been raised. The answer was because it bundled its products with a business opportunity. A pyramid scheme as Ackman mentioned in his presentation was “the organization is deemed a pyramid scheme if the participants obtain their monetary benefits primarily from recruitment rather than the sale of goods and services to consumers.” He went on with the list of 5 deceptions that Herbalife has made.
First, in the table of active leaders and average earnings in different distributor’s levels, Ackman claimed that the company has moved 93% of its US distributors with the base earning of $0, off the table. Second, the “gross” earnings were shown in the average earnings, not the net earnings. Distributors were additionally charged with a lot of expenses, Ackman said following the former Herbalife non-sales leader’s blog, the expense was around $2,000 in 3 months for website setup, Decision Package, etc., not including the money to purchase Herbalife’s products. Third, he said that Herbalife did “cherry-picking active leaders” with the highest earnings. Fourth, the company overstated that over 25% of distributors would reach
Supervisors, however, data have shown the percentage of sales leader over total distributors has been lower than 25% for the last 4 years. And the last deception Ackman pointed out was the difficulty to get to the top. He gave out the example of Ireland, Herbalife began its business in this country in 2000, and in ten years, no one had successfully got in the Millionaire Team. In the period of 2004-2009, Bill Ackman estimated that the chance to get into the President Team would be 1/10,000.
Highest Payout to the Top Distributors
Compared with other peers in the MLM industry including Nu Skin (NYSE: NUS) andTupperware Brands (NYSE: TUP) and Medifast (NYSE: MED), Herbalife was paying the highest commissions for its top 1% distributors. Medifast was paying only 31% of total commissions to its top 1% distributors, whereas the rate was 49% for Tupperware, Nu Skin was quite high, at 80%, but not as high as Herbalife, of 88%. Ackman laid out the comparison of the distribution compensation of Herbalife and Avon Products (NYSE: AVP). Avon’s royalties were descending from the first to the third level, and the recruiting rewards stop at the fourth level. Differently, Herbalife was paying flat royalties, in addition, the recruiting rewards were added up by the Production Bonus and Mark Huges bonus. Thus, the total payout of Avon was 14.7%, whereas Herbalife had the total payout of 23%.
Why Herbalife Could Keep Going in More Than 30 years?
Many people might wonder if it was a pyramid scheme, why it has kept operating and expanding for the last 30 years? Ackman said that it just kept entering new countries. In any countries, Herbalife experienced the “pop and drop” phenomenon. It means the sales in a new country could “pop” significantly, then “drop,” then Herbalife didn’t disclose the sales in that country separately. The example was Japan after 2005, Israel after 2001, and Spain, France, Germany after 2001, etc. In addition, in order to make earnings smooth, Herbalife re-classified the countries several times in the last 5 years, particularly in 2006, when South America was grouped in one reporting region with Southeast Asia. Ackman thought that the future growth might be very limited for the company, as in the 2008-2011, Herbalife has entered 14 countries with an average GDP per capita of more than $4,200, including Lebanon, Georgia, Mongolia, Ghana, Vietnam, Ecuador, etc.
Foolish Bottom Line
I myself find the presentation quite fascinating. Bill Ackman has dug deeply into the facts and figures for his short-the-stock thesis. Different investors might have different views, different opinions. It is worthwhile for us to be informed, and to gather all pros and cons about each investment we would like to establish positions. On the last note, Bill Ackman pledged that he would donate all the personal after-tax profit from Herbalife’s trade to charity. (Investors might see the full presentation on the Business Insider website.)