Herbalife is a pyramid scheme is because it is an endless chain. And therefore, it is inevitable that the business must ultimately fail, disappoint those at the bottom of the scheme, and therefore should be shut down.
Disclosure: I am short HLF. (More...)
In a recent article titled "Shattering the Personal Consumption Myth" I outlined how no rational individual would actually sign-up to be come an Herbalife (HLF) distributor to acquire Herbalife product at a discount for personal consumption. Rather, the only rational reason to pay $59 to acquire an IBP and to load-up on Inventory would be to pursue the "business opportunity" and to load-up on enough merchandise to "buy your discount", and to pursue the dream.
Nonetheless, Herbalife longs and the company continue to cling to the irrational notion that 71% of Herbalife's distributors are just "discount customers".
In this article, I would like to further deconstruct the mythology that Herbalife is a legitimate business to demonstrate, categorically, that the reason Herbalife is a pyramid scheme is because it is an endless chain. And therefore, it is inevitable that the business must ultimately fail, disappoint those at the bottom of the scheme, and therefore should be shut down.
Today, on the news that Carl Icahn has invested in a 14% of Herbalife's common equity with an option to increase this stake, Herbalife's market cap has surged over the past few days to $4.4 billion or roughly 9x eps guidance.
Considering the fact that 30 million shares are short, the company is buying back stock and 14% of the float is now in friendly hands, this isn't exactly a squeeze of epic proportions. This begs the question: What is Mr. Market seeing that long investors like Mr. Icahn are not?
The answer is clear.
Herbalife is a company on spin cycle because its entire business model depends upon recruiting and therefore is an endless chain.
In this article I would like to explore a number of metrics that demonstrate that there is no productivity nor leverage in Herbalife's marketing efforts.
First, let's look at Net Sales per Distributor for the past 5 years.
Herbalife produced $2.4 billion of Net Sales
Ended the Year with 1.9 million distributors
Avg. Net Sales Per distributor was $1,263
Herbalife produced $2.3 billion in Net Sales
Ended the Year with 2 million distributors
Avg. Net Sales Per distributor was $1,150
Herbalife produced $2.7 billion in Net Sales
Ended the Year with 2.1 million distributors
Avg. Net Sales Per Distributor was $1,285
Herbalife Produced $3.5 billion in Net Sales
Ended the Year with 2.7 million distributors
Avg. Net Sales Per Distributor was $1,296
Herbalife Produced $4.0 billion of Net Sales
Ended the Year with 3.1 million distributors
Avg. Net Sales Per Distributor was $1,290
This data series shows that there is a linear relationship between the number of distributors and the topline sales that the company generates. Effectively, the growth in the topline is correlated 1:1 with the growth in the number of distributors recruited.
Q. What are the implications of this data?
The 80/20 rule does not seem to apply in the Herbalife world. If 20% of distributors were driving 80% of Net Sales, we would expect to see Avg. Net Sales Per Distributor decline over time. Effectively, the impact of a new recruit on the Net Sales of the company would be non-linear. That is to say that the new recruit would account for a smaller percentage of the company's Net Sales v. those who have participated in the scheme for longer. This is not what the data reveals.
Rather, the data shows that the purchases of product per distributor remains the same as the base of the pyramid expands.
This also supports the conclusion that growth in Net Sales is driven by recruitment v. by the ongoing service of existing customers plus additional recruits.
Can we construct additional evidence to support this assertion?
I would like to introduce a new metric to determine Herbalife's reliance upon recruiting. This metric is Net Sales (NS) divided by New Recruits (NR). Effectively this is a productivity metric.
If Herbalife's recruiting efforts are successful at building a franchise business than the value of NS/NR increases over time. Effectively, the higher the value of NS/NR over time the less topline sales is dependent upon recruiting.
If not, then the business is on Spin Cycle
Let's call Net Sales NS
New Recruits NR
Net Sales Per Recruit X
Then, what I would like to do is compare the variable Y in a time series. So, let's call it X1, X2, X3, X4, etc.
If X2/X1 1 then Herbalife's business is not dependent upon recruitment to sustain its topline growth because it retains customers.