Long only, contrarian, value, short only
In July of 2016, the FTC issued a report on their investigation into HLF's business practices.
The report concluded that there were no significant retails sales, and revenues were derived from coerced consumption.
Herbalife settled with the FTC agreeing to a $200M fine and a restructuring of their business model that they appear to be violating.
I believe reported levels of reward-able sales and preferred customers are unrealistic and that further action against HLF by the FTC is likely. This would have serious implications for investors.
I'm sure just about anyone reading this article understands the basics of the Herbalife (HLF) saga over the past couple of years, and therefore, I am not going to spend a lot of time rehashing it. In short, Bill Ackman accused the company of being an illegal pyramid scheme and shorted the stock. Carl Icahn took the opposite trade and made no bones about his motive to settle an old score with Ackman. Ackman's high-profile public accusations forced the Federal Trade Commission to investigate Herbalife's business practices, and in July of 2016, the FTC issued a report concluding they found that there were no significant retail sales and that coerced consumption was the only substantial source of revenues, which by definition is a pyramid scheme.
(6) the court found that personal consumption by a distributor's downline does not satisfy the Koscot requirement that sales be to the "ultimate user." Therefore, when designing a multilevel marketing plan, the approach presenting the least risk is to institute and enforce a rule that at least 70% of a distributor's purchases result in true retail sales to persons who do not participate in the compensation program.
The FTC also announced a settlement with Herbalife whereby Herbalife agreed to pay a $200M fine and to a consent decree that required the company to restructure their business in order to ensure most of their revenues were derived from sales to end users who were not business opportunity seekers. The settlement required that HLF segregate participants into two basic categories: Preferred Customers and Business Opportunity Seekers. Preferred Customers cannot participate in the business opportunity; however, they can buy products for their own personal use at volume discounts. The Business Opportunity Seekers rewards for personal consumption are restricted to about $200/ month of volume. In addition to this, there is a requirement to create invoices for retail sales and to keep customer information. Finally, total company-wide business opportunity rewards are severely limited if company-wide "reward-able" or non-coerced consumption-based sales are less than 80% of total sales. I will be exploring the 80% reward-able sales in this article.
The consent decree allowed HLF 10 months to fully comply to the business restructuring, and after the 10 months, Herbalife's U.S. sales took a quick 18% hit. However, they rapidly recovered, and in their latest report, U.S. sales are up 20% year over year. Ackman was forced to cover his short as HLF sales rebounded. His detractors celebrated the victory.
Icahn won, Ackman lost, cased closed we can all go home now... right? Ackman has lost. However, Icahn hasn't won (unless you count sticking it to Ackman) until he sells, and I believe there is substantial evidence that Herbalife is not telling the truth about how much of their revenue is derived from coerced consumption. If I am correct, this could lead to additional actions taken by the FTC that would have serious consequences for their U.S. business which Ackman suggested accounts for about 40% of their total profits. Further action by the FTC would also not go unnoticed by regulators in the other countries that HLF operates in.
To make the case, let's start with some of the FTC's findings from their investigation into Herbalife's business.
Defendants Do Not Offer a Viable Retail-Based Business Opportunity53. The overwhelming majority of Herbalife Distributors who pursue the business opportunity do not make anything approaching full-time or even part-time minimum wage because the promised retail sales to customers simply are not there.
Defendants' Business Opportunity is Based on Recruitment
81. Notwithstanding Defendants' express and implied representations that Herbalife offers a retail-based business opportunity, in truth the only way to achieve wealth from the Herbalife business opportunity is to recruit other Distributors. Purchases by these recruited Distributors, referred to as a "downline," generate rewards for the sponsoring Distributor. (See ¶ 119.) Through a variety of channels, Defendants admit, expressly or by implication, that recruiting is the key to financial success.
To summarize as of July 15, 2016, when the FTC issued their report and announced the consent decree, Herbalife's revenues were substantially derived from coerced consumption (non-reward-able), according to the findings in that report. The following information from Herbalife details "reward-able sales as they were supposed to be implementing the restructuring agreed to in the consent decree.
"We have a few slides included on our last investor presentation that further describes the 80% methodology and you can find this information on our investor website. As of today, we are currently tracking close to 60% towards the 80% threshold.
".... we believe we are on track to meet the 80% threshold, and I'm pleased to report that, at the end of April, our calculations show we are in excess of 70%."
Once again, based on the FTC's investigation into Herbalife's business practices, they found that, as of July 2016, an insignificant amount of sales would qualify as "reward-able" under the terms of the consent decree. Seven months later, Herbalife claims ~60% of sales qualify as reward-able. Ten months later, Herbalife claims over 70% of sales qualify as reward-able. And, they currently claim over 80% of sales are reward-able, which recall is the threshold for avoiding severe limitations on business opportunity rewards.
To restate this, based on the FTC's investigation into Herbalife's business practices, as of July 2016, almost all of HLF sales were based on business opportunity seekers inventory loading in order to advance in a get rich quick scheme or conversely almost none of their sales were to participants not involved with the HLF business opportunity. Seven months later, and by some miracle, 60% of sales were to non-business opportunity seekers (a bit of biz op volume is reward-able). Ten months later, it's over 70%, and it's currently more than 80%.
That's unbelievable... No, really; it's literally unbelievable or, put another way, almost impossible. Particularly when you consider there was hardly any disruption to their U.S. revenues while they were making this astounding transition. From their filings over this period, U.S. sales were up 10% in Q3-16 and then North American sales (I couldn't find U.S. alone) were down 1% in Q4-16, and this covers most of the period when they were supposed to be transitioning from almost all of their sales being based on inventory loading by biz op seekers looking to get rich quick to ~60% actual retail customers not in the business opportunity. North America sales were down a modest 7% in Q1-17 when they made the further transition to ~70% non-coerced consumption sales.
I'm going to take a break from reward-able sales and explore another incredible transition from the FTC's findings or the transition of the vast majority of participants involved in the business opportunity to the vast majority of participants not involved the business opportunity and only purchasing for self-consumption. Prior to the FTC investigation, Herbalife argued that 86% of their "business partners" were only participating in order to get a volume discount for "self-consumption" and were not participating in the business opportunity. Here is what the FTC's investigation concluded about this claim:
104. Regardless of the number of so-called "discount buyers," it is clear that collectively they could account for only a small percentage of the volume of Defendants' products sold in the United States. Even using a grossly overstated measure of "discount buyers"-that is, counting as "discount buyers" the roughly 80% of participants who are not "Sales Leaders"-such Distributors collectively account for less than 25%of the volume of Defendants' products sold in the United States. The remainder, over 75%, is purchased by Distributors at the "Sales Leader" level, who are clearly pursuing a business opportunity.
This brings me back to an article I posted last year that I forgot about. The article was about a huge push to sign up Preferred Members, and looking back at it, I believe I failed to truly see the true significance. Here's a high-level distributor quote embedded in the article the article:
If you do not have customers Herbalife is requiring you to switch be a Chartered Preferred member!
***If you do switch and get a few customers you can switch back to being a distributor***
You will get $25 credit until January 30th. This is Herbalife rules! Let us know if you need help! Tag your team please!
Recall preferred members are not in the business opportunity and only participating to get a volume discount for self-consumption. According to the FTC's investigation, less than 25% of members would qualify as Preferred using a grossly overstated measure of "discount buyers" (or much less than 25% using a reasonable measure).
Here is management's disclosure about the proportion of Preferred members ten months later in May of 2017:
We continue to make significant progress with the segmentation requirement of the agreement. We began segmenting our existing U.S. members into preferred customers and distributors in October, and today, the total number of preferred customers is approximately 360,000 people. In addition, since January 13, when segmentation became available at sign-up from the U.S. members, 80 percent of our new members are signing up as preferred members and more than 60 percent of all those placing orders in the first quarter were preferred members.
Once again, we have an unbelievable transition from the FTC finding much less than 25% of members would qualify as preferred going into the restructuring to 60% Preferred members in the first quarter of the transition, and as noted previously, there was almost no disruption to revenues over this period.
I've heard anecdotally that preferred members are being told that buying product to "represent the company" is part of a business opportunity or, in other words, they were misled about what they were signing up for when they were pushed to choose preferred. I had to look up their definition of a "Preferred" member to understand what it is, so I can see how people from low income and low education rate communities that Herbalife targets could be misled about what they were signing up for.
If the anecdotal evidence that members are being pushed to sign up for preferred status but misled to think they are in a business opportunity is accurate and pervasive, and I have a strong hunch it is, then this would also be a very simple explanation for how Herbalife has been able to report 60% reward-able sales volume with only a seven-month transition from no significant reward-able sales volume. Sign participants up as preferred so that all personal consumption is reward-able, but mislead them into believing they are still in the business opportunity for existing members or joining a business opportunity for new members. You can then keep up the coerced inventory loading and report it all as reward-able sales.
Next, I'd like to take a look at the HLF business model. They target low income communities full of financially unsophisticated people with little disposable income. Pre-consent decree they sold a get rich quick scheme whereby these people were conned into a "business opportunity" that pushed them to sign up everyone they knew to compete against them selling commoditized shake mix door to door at 2X to 3X the retail price highly branded competitors were selling equivalent products.
I personally don't see misleading preferred customers into thinking they were in a business opportunity as much of a change, and it's about the only logical explanation I can come up with for how they managed the unbelievable transition from no significant reward-able sales to 70% reward-able sales in 10 months under a consent decree to overhaul their business plan. It amounts to no change except for how they cover up coerced consumption.
Getting back to Ackman lost, Icahn won; Ackman did indeed lose; however, as far as I know, Icahn is holding his HLF position. I think I'm on to something with the push to preferred members; however, even if I'm wrong, there is still no logical explanation for how HLF managed the miraculous transition from almost all revenue derived from coerced consumption to ~70% from non-business opportunity sales in 10 months. It also doesn't explain how they managed the other amazing transition of substantially less than 25% preferred members to probably almost all preferred members at this point.
I've been depressed that the FTC seems to be asleep at the switch; however, as I started putting the miraculous transitions together in my mind, I have come to believe it's near impossible for the FTC and the Independent Compliance Auditor mandated by in the consent decree to overlook this.
To conclude this article; I have a story about a little penny stock called Worldgate Communications (WGAT) I used to follow for entertainment because their Yahoo m.b. was a riot. About a month before they were due to run out of cash and have to file Chapter 7 (as I was predicting), they were white-knighted by an MLM called "American Communications Network" or ACN. WGAT hawked a video phone, and ACN sold video phones among other communications related goods and services. ACN took ~60% stake in WGAT for a couple million dollars (petty cash) and signed a deal to buy ~$5M worth of phones. This was the only significant deal WGAT had. I spent about a year and a half on the WGAT Yahoo message board debating ACN founder and WGAT COB and acting CEO Rob Stevanovski on the merits of selling phones to yourself before he suddenly disappeared. About another 6 months later, WGAT filed chapter 7. The moral of the story is regulators sometimes work in mysterious ways. If you are long HLF, it's something to seriously consider.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.