Thursday, July 2, 2015

Sirius Minerals: Financing will be a serious challenge

Sirius Minerals has just received approval for their polyhalite (potash) mine under the North York Moors National Park.

The stock was up about 50 percent yesterday and the market cap is now about half a billion pounds.

Now they have the small matter of financing the mine, building it and operating it to specification.

It is a big project. Here is the corporate video:




The mine is roughly 1500 meters deep and workers need to descend by very long shafts.

The video proposes mining with continuous mining equipment (long-wall coal would be an analogy - but coal is never mined that deep).

Longwall equipment is expensive to maintain.

The rock at York Potash looks pretty hard. Moreover deep mines have all sorts of problems (eg the rock in the wall simply explodes as it is depressurised) and the mines are usually fairly hot.

Deep mining is - usually - difficult and expensive. Hard rock leaves high maintenance costs. [Polyhalite is 3.5 on MOHs scale, a lot harder than coal but not truly hard.]

Still, according to the company and its feasibility study this will be a very low cost mine. The feasibility study gives costs as follows:



Yes, that is USD36.9 per tonne in operating costs. Net of processing at port the cash costs are USD24.9 per tonne.

Now I like to compare this to iron ore operating costs.

Iron ore is pretty simple to mine. It comes in large open cut seams, you don't do much to it and you load it onto trains and then to a port. Moreover it is done on huge scale - hundreds of millions of tonnes per year - which tends to lower cash costs (per tonne) dramatically.

Still York Potash estimated cash costs are about the similar to the West Australian ultra-large very low cost iron ore mines. [The linked Sydney Morning Herald article questions the viability of iron ore mines at prices around $35 per tonne.]

Sure some iron ore mines have lower cost than that - but the cash costs cited here are consistent with mega-scale open cut mining, not mining 1500 meters underground. The cash costs that York Potash suggest are in the range of the lowest cost large scale open-cut mining operations in the world.

The management of Sirius came from Fortescue - a giant Western Australian iron ore mine. So they must have learned something about low cash cost mining.

I am just wondering how they do it. Because without a reasonable explanation as to why this is just so cheap I am not buying it.

Count me out of the financing. Financing and building something that cheap to run is going to be a serious challenge.





John

PS. There is a mine (Boulby) owned by Israel Chemicals operating about the same depth in the same area. The cash costs are likely to be in the mid-200s per tonne.

PPS. If you want to understand the challenges of mining hard rock really deep this Wall Street Journal story on mining in South Africa is instructive. [The proposed Yorkshire mine is about a third of this depth and probably in less brittle rock so the WSJ story overstates the problems that York Potash might have.]

This South African mine has thousands of staff and removes 6,400 tonnes of hard rock per day. By contrast York Potash intends on removing 35,000 tonnes per day at much lower costs.

Still this is what the WSJ has to say:

A deep mine is a truce that will always break. Mining at depth makes rock unstable. Every day at Mponeng mine they detonate 5,000 pounds of explosives. Every day they take away 6,400 tons of rock. The laws of compressive force dictate that the rock will try to close the spaces left by mining. To prevent this, engineers backfill stopes with rock and concrete. They reduce rock stress at the mining face, "softening" the rock before they blast it by drilling complex patterns around the blasting holes. In one deep mine they "fool the rock" by drilling out six-foot horizontal slots above the stopes. Since stress propagates through rock, but not through space, the empty spaces hinder the transmission of stress. 
In tunnels, yard-long rock bolts anchor the unstable rock on the tunnel roof to the more stable interior of the rock mass. Patterns of rock bolts inserted in clusters are said to "knit" the rock together. Wire mesh and sprayed concrete stabilize the tunnel walls. Seismic sensors in the mine detect tremors at the first twitch, warning men to leave the rock face. 
Earlier the article indicated just how much force rock explodes with:
Some of the rockbursts had been so powerful that other countries, detecting the seismic signature, had suspected South Africa of testing a nuclear bomb. 
==

Whatever, despite extreme depth and the problems that arise Yorkshire Potash will not be expensive to operate. The feasibility study suggests this is all going to be done for open-cut mine cash costs.

--

For mine opponents there may be no need to lament the decision to mine. With this sort of financing and engineering requirement I suspect the York Moors National Park is fairly safe.

Thursday, June 11, 2015

Herbalife - the (very) long post

This is a very long post. I have done a lot of work on Herbalife that should be made public – and I am travelling on several long-haul plane journeys which gave me time to splice it all together. [Now in New York via London and the Middle East.]
There are Herbalife groups all around the world and they reflect the character of the community they are in.
But I want to start you in Israel in a mostly Arab (though mixed) town. It could be Nazareth (but it isn't). There are mixed clubs throughout Israel. I am assured there are non-mixed clubs too but we have not been to them. For example there are clubs in Rahat (the largest Bedouin city in Israel).
My colleague - who took the notes from this visit - promised the relevant people that he would not reveal their secrets - so I am not going to tell you the particular town and I have changed the name of the people at the club. [The Arab womens' names I have chosen are to the best of my knowledge appropriate alternatives. If I have that bit of the culture wrong I apologise.]
The club is managed by Asriyah, who is a belly dance teacher. The members meet every (almost) every evening and have a similar process:
1. Drink the shake (the food) – which costs around 12 shekel.
2. Drink a Herbalife tea.
3. Drink water with Aloe Vera.
Strangely this order differs from Herbalife clubs in countries I have visited where the tea or water comes first.
This whole meal costs 18 shekel (USD4.70) which is cheap relative to the meal replaced. The club saves members money. [The meal being cheap relative to the meal replaced applies in most markets I have seen but not in China.]
During sharp weight loss a member might have ten of these meals a week, adding another meal per day. Long time customers often drop to five meal replacements per week - which is usually sufficient to keep the weight off.
While they drink the aloe water, there is a discussion “managed” by Asriyah.
My colleague arrived late (when they were drinking the water and joined in). Asriyah asked each member to tell a bit about himself or herself and their progress.
There was Lubabah – who is religious and works in a bank – she has been a member for 6 months and has lost 18 kg. She brought in another 10 members (her friends), all similar background. Each one lost between 7 – 18 kg, and they also measure the diameter loss (they total around 100 cm).
Importantly, Asriyah knows all the numbers and is constantly motivating them.
These people come with bad habits (they hardly drink water - and instead drink Coca Cola, they eat a lot of carbs and do no sports).
They all have fast results with (relatively) small effort (they are not doing the tough sports, just the specific diet and some exercise).
There was also a priest, who lost 12 kg and has claimed that he tried sports, but ended up eating pita bread with chocolate so did not lose weight. He measures weight loss and muscle gain.
There was an Arab woman who lost 21 kg, so brought her daughter was well.
She told us that she never hears any good words from her husband – it is all about serving him and how fat she was. For the first time in her life she feels “like a million dollars” and is much happier.
Asriyah has 5 Ethiopian customers – one lost 27 kg and is getting great feedback from her kids, and some other requests from her husband (she smiled and everyone clapped).
I could continue with these – my colleague heard 30 members. The common theme was the amazing results, the understanding of proper eating habits which some did not have, and the positive feeling due to the change. The average “duration” of the customers is over 6 months, and some were there for 2 years.
Asriyah knows each customer’s data by heart, and is the motivator – she WhatsApp'ed them a few times a day and asks to show her what they ate – they all “complain” but love her and feel they that at last someone cares about them.
The woman who served my colleague water has 8 customers and is “in process” of opening up her own club, but is still being “mentored” by Nuwwarrah (an upline member). The organization recommends having at least 10 customers before one opens a club. [The organisation in this context is the organisation run by a very senior distributor rather than the company – but of that I could not be sure.]
After this finished (each one got his/her chance to talk), they all have a fitness session – some indoor (the Arab women) and some out in the park. Exercise was some kind of belly dancing. It does not look too hard to us, yet one must remember that some have not done ANY workout for years.
It is pretty obvious this is working really well.
(a). The clear results of the program – they really lose weight and become non-fat.
(b). The emotional support – this is the reason why one needs clubs – for the support – just like we see running teams. People do this better in a group than alone.
(c). Social. They become very close friends. The atmosphere was very open, and they get a chance to discuss their weakness (fat, loss of control) with no shame, because everyone has a similar problem. 
This is like the alcoholic groups or parents that meet for child treatments (e.g. ADD).
There are other aspects too.
(d). Importance. For some of these people, this is the first and only time they are “recognized”. Some described a life where no one sees them – they are there to serve, are not attractive and have very low self-esteem. It is not easy for “normal” successful people to understand this aspect – they take it as a given, yet fat people suffer from low esteem from an early age – they become used to being laughed at. 
Medical claims
Herbalife distributors are not allowed to make medical claims as a matter of company policy - but in discussion with club members medical claims were made. There are some real medical improvements that are a consequence of this diet, and the lives of some have improved a lot. Diabetic treatment was minimized, and many other examples were given.
My colleague was skeptical about the extent of medical claims. Whatever: losing weight (per-se) rather than Herbalife products really does have some major effects.
Along the way I have met (not at this club) people who claim that Herbalife cures arthritis - and that is clearly false - but losing 20 kg reduces strain on joints.
Remuneration
Asriyah makes around 15K shekels a month on this activity, which means she can stop her other work – it is a substantial motivation. However when asked what motivates her, you can see that it is the feeling of doing good to others, gaining a large number of friends (she considers ALL members as friends) and the contribution to others she has. It was the same response from up-line supervisors. They enjoy what they do, believe they have a great cause and results, gain many friends (“it is the people – that is what we enjoy”) and make a proper living. Some of the up-line supervisors make roughly 100K shekel/month (good money indeed given their prior circumstances). However they have a large number of clubs beneath them.
This is typical
I have visited 17 different Herbalife distributors in 7 countries including China. There are commonalities: the product is sold by creating and maintaining a sense of community and results and health claims are ubiquitous. Several friends have visited clubs in still other countries - and reported back similarlu.
There are lots of consumers who have built the club into their lifestyle. Sure they pay more than protein shakes are worth - but they get more than protein shakes. They get a community, friends and the support needed to get results.
This is what the facts on the ground look like. They do not bear any resemblance to Mr Ackman's long presentation. There are clubs catering to police officers in Miami, clubs run in Asian communities in Sydney, clubs which are Moslem social meetings in Malaysia, strangely different social-groups in China [which I will discuss below] and clubs in beer-bar-brothels on the beach in Cambodia and Thailand where local poor people sell diet shakes to overweight German sexpats [no I am not kidding and I will detail one of those later in this note too].
But in every case the club sells real product in an ethical manner.
Herbalife is in my opinion a highly ethical company. This is completely in contrast to the received opinion on Wall Street. It does good business in a fine manner and it has many years of growth ahead of it. [Incidentally I think the growth is a near certainty too – and explain my reasons below.]
It is the stock in the portfolio I am most proud to own. It is also the stock about whose long-term prospects I am most bullish.
This was a surprise to me
You learn a lot of things being a facts-on-the-ground driven professional investor. The world is a complicated place and businesses work in ways that you do not expect.
However Herbalife has surprised me more than any company I have studied in the last decade.
When Bill Ackman made his original presentation I said this:
I am utterly convinced by everything in Bill Ackman’s presentation except the final conclusion – that Herbalife’s stock will collapse. I took a long position on Christmas Eve. I suspect that Herbalife is so profitable and so powerful they will see Mr Ackman’s attack off – and the easiest way to do that is to buy back stock (and make the stock go up). Mr Ackman has given them the incentive to return their huge (but tainted) profits to shareholders (and I plan to be a recipient shareholder).
Much to my shame I even got on CNBC and called management "scumbags".
If you had told me that a business whose business model was persuading people to sell diet shakes and other potions to their friends at approximately 1.3-1.5 times fair retail price was an ethical, high quality business I would have told you that you were insane.
I had preconceptions driven by ideology. An ideology that might be described as ivory-tower liberal.
But I don't care what your ideological preconceptions tell you. If the facts on the ground tell you that you are wrong then you are wrong. And it doesn't matter who you are either. You could be Warren Buffett, David Einhorn, Bill Ackman or my mother (all of whom are usually right) but if the facts on the ground disagree with your ideologically driven preconceptions then you are wrong.
Bill Ackman's thesis is utterly wrong - and the morality that surrounds his thesis is also misguided.
This is a long post however to go through all of his arguments in detail. I guess it is the basis of a book on the Herbalife saga. Someone will write that book (it won't be me) but whilst the issue is still live I want to write the first draft of history.
The Herbalife debate thus far
The Herbalife debate comes almost entirely from the presentations of one man: Bill Ackman. Mr Ackman has made four three hour presentations - and the story has changed somewhat over those presentations.
However before any Ackman presentation there was a single set of poisonous questions by David Einhorn on a Herbalife conference call.
Here is the transcript - but it takes some explaining to understand why these questions were so poisonous:
"Einhorn Question: How much of the sales that you’d make in terms of final sales are sold outside the network and how much are consumed within the distributor base?
HLF Answer: So, David, we have a 70% custom rule which is basically says that 70% of all products sold to consumers or actually consume my distributors for their own personal use. So obviously what we’ve seen with nutrition clubs is that we now have visibility for the first time to our customers. We know that we reported on this call for the first time the number of commercial clubs around the world, which is in excessive of 30,000, so that has given us feasibility to the tremendous amount of products that are being sold directly to the consumers and we see that as a growing trend in our business.
Einhorn: So, what is the percentage that actually sold to consumers that are not distributors?
HLF: So, we don't have an exact percentage David because we don't have visibility to that level of detail.
Einhorn: Do you have an approximation?
HLF: So well again going back to our 70%, where we believe is that it is that 70% or potentially in excess of that.
Einhorn: Okay. What is the incentive for supervisor to sign somebody up to become a distributor as opposed to – if they’re just going to consume for themselves as opposed to just selling them the product for the markup. How does the distributor – how does the supervisor come out better?
HLF: Sure. So, I think there are two reasons for that. So, we know from our business today that many of our future supervisors and business builders come in as customers and then they become distributors. So, the benefit from a supervisor is the ability for greater retention of that customer/distributor because they are now earning a 25% discount. The second issue is that it preserves linage. So obviously, if I sign you up David as a distributor, my hope and my expectation is that based on the tremendous product result that you’re going to achieve that you’ll have friends and families go to you and say, gosh David you look great, what do you want. You’re going to respond to them, I’m on Herbalife, and that will encourage you to say, wow maybe this is a business opportunity I could be interested in. So, the benefit for me as your supervisor is one, the discount that you would get and that for my greater likelihood of retaining, it was a permanent customer and secondly, the hope that at some stage, you will decide to do the business and therefore that you are already in my lineage and is part of my group.
Einhorn: Right. But just trying to understand this clearly, if I sell to a customer, I bought it - I'm a supervisor, I buy at a 50% discount, I sell to a customer, I make 50 points, if he pays the full price. If he signs up with a distributor and buys it himself, he gets a 25% discount and I get seven points as a royalty. Is that how it works?
HLF: No, you would get the other 25%.
Einhorn: I will get 20% plus the 7%.
HLF: So, unless you're on royalty, you would simply (inaudible) in the difference. So, you are in a 50% discount, you are selling at a 25% discount, and so the difference between the two is your profit on that sale.
Einhorn: Right, so if he signs up with a distributor and buys it for himself from Herbalife, I still get the 25%.
HLF: That is correct.
Einhorn: OK. Good. One last question, when you had your previous 10-K, you disclosed three groups of distributors at the low-end. You called 29% self consumers, 57% small retailers, and 14% potential sales leaders and then that disclosure did not repeat in the subsequent 10-K. So, I got two questions, first of all how do you track that and how do you characterize and know which ones are which? And second, why did you stop disclosing that in the last 10-K? Is that something that you stopped tracking or just stopped disclosing?
HLF: Hi, this is John. The criteria for grouping distributors into different classes was based off of their volume purchases and we are making assumptions that people below of certain volume. While doing the business, they were buying soft consumption and I don’t remember the exact amounts, but I can get it to you after the call, as how we delineated between the three classes. And one the reason that we took out of the 10k is a change in CFO from which to me I didn’t view it is valuable information to the business or to the investors. However, we can easily provide the exact same breakout going forward if you would like [indiscernible] into our investors. Again, I don’t remember the exact delineation between the three classes, but I can certainly get it to you. Our objective is to be completely transparent, so."
There is a reason this questioning is so poisonous. In Queens (where Mr Einhorn went to visit clubs) it is almost impossible to find someone in a club who has not signed a distribution agreement.
When you ask them why they signed a distribution agreement they will tell you it is so they can get the product at a 25 percent discount when they consume it at home (mostly rarely). Most of it is consumed in the club. That said – my quick look around Queens suggested that just about everyone has signed a distribution agreement. [This is not true in other parts of the world – but as far as I know Mr Einhorn had not visited clubs outside the five boroughs of New York.]
And there are court cases on what defines a “pyramid scheme”. And if you take the court-cases decided before the Einhorn questions literally it turns out to be very difficult for Herbalife.
A case has been decided since (the appeal on Burn Lounge) which makes life considerably easier for Herbalife. However that decision post-dated the Einhorn questions.
When Einhorn asked his question much MLM law hinged on two 1970s cases on what constitutes a legal or illegal multi-level marketing scheme. The FTC tried to close Koscot Interplanatory (an MLM selling cosmetics) and Amway. They succeeded on the former and lost on the latter. The Amway rule created safe harbours through which the entire MLM industry tries to operate [or in some cases in my view cosmetically pretends to operate].
The basic facts of Koscot look like a pyramid/ponzi to a casual observer:
1. The sales person - called a "beauty advisor" puchases products from her sponsor (who may be a supervisor or director) at a 40 percent discount, for sale to the consuming public. The beauty advisor receives a refund bonus from her sponsor each month, based on the total retail volume ordered during the month. Entrant qualifies by investing $10 for a starter kit.
2. The supervisor purchases products from the company at a 55 percent discount for distribution to his beauty advisors and direct sales to the consuming public. The supervisor receives a special commission for each new supervisor order he creates, $500 or 25 percent of the $2000 paid for the initial order. An entrant qualifies as a supervisor in any one of these ways:
a. By investing $2000 immediately;
b. By purchasing $5400 in Koscot cosmetics (at retail value) from his sponsor;
c. By selling a portion of the required $5400 volume through his organization and purchasing the balance in one lump sum.
3. The director purchases products from the company at a 65 percent discount for distribution to his direct distributors (supervisors and beauty advisors) and for direct sales to the consuming public. The director is entitled to a 10 percent special commission on all of his supervisor's purchases. He receives $500 for each supervisor order that he sells. The director sponsoring a new director is also entitled to a 65 percent commission ($1,950) on the $3,000 additional inventory which the new director is required to purchase. An entrant qualifies as a director by: a) becoming a supervisor, purchasing the additional $3000 director inventory and selling a new supervisor order in order to replace himself in his sponsoring director's organization; or b) by initially investing $5000 and becoming known as an apprentice director until he fulfills all the necessary aforementioned requirements.
These positions are described more fully to the prospective investors at 'Opportunity Meeting' held weekly in various locations across the country. At such a meeting, a movie is shown and speeches are made which concentrate upon the unlimited potential to earn large sums of money in a relatively short time by recruiting others into the Koscot program. In most instances, the opportunity meeting will closely follow the script provided by respondents as found in the distributor's training manual. This meeting is run in such a manner as to excite those attending and to induce them into making an emotional decision to invest in the program.
It would be pretty hard not to determine this was a pyramid. Indeed the court suggested this was “inherently deceptive and fraudulent” and the Federal Trade Commission [the relevant government body] has the power to regulate “deceptive” and “unfair” practices - thus giving the FTC power to close Koscot. This has been taken ever since as giving the FTC considerable power to regulate multi-level marketing.
Amway however got off. The Wikipedia page on the Amway case is here:
And to quote:
Amway has avoided the abuses of pyramid schemes by:
  • not requiring an entry ("headhunting") fee;
  • making product sales a precondition to receiving the performance bonus;
  • requiring the buying back of excessive inventory; and
  • requiring that products be sold to retail consumers.
The administrative law judge also found that "Amway is not in business to sell distributorships and is not a pyramid distribution scheme."
In the opinion section of the ruling the Commissioner stated:
Two other Amway rules serve to prevent inventory loading and encourage the sale of Amway products to consumers. The "70 percent rule" provides that "[every] distributor must sell at wholesale and/or retail at least 70% of the total amount of products he bought during a given month in order to receive the Performance Bonus due on all products bought…." This rule prevents the accumulation of inventory at any level. The "10 customer" rule states that "[i]n order to obtain the right to earn Performance Bonuses on the volume of products sold by him to his sponsored distributors during a given month, a sponsoring distributor must make not less than one sale at retail to each of ten different customers that month and produce proof of such sales to his sponsor and Direct Distributor." This rule makes retail selling an essential part of being a distributor. The ALJ found that the buyback rule, the 70-percent rule, and the ten-customer rule are enforced, and that they serve to prevent inventory loading and encourage retailing.
—— 93 F.T.C. 618: Opinion, page 716
Essentially if you sell washing powder to someone and they consume some if themselves that is okay (internal consumption is okay) but when the consumer is consuming it all internally (and it is a lot) it is good prima-facie evidence they were stuck with it and hence a pyramid.
The court/judgements wanted to work out the difference between forced and unforced internal consumption and came up with this 70 percent rule. If 70 percent of the product is sold external to the network it must be real. The Amway case also required buy-back of excess inventory (although it allowed it to be bought back with a discount-restocking fee) and it required there be a number of external customers who were identified.
Herbalife clubs in Queens do not obviously meet this criteria. They work by being alcoholics anonymous for fat Hispanic people. You go there and it is the social support network that gets you to stick to the diet. Almost everyone “signs up” as a distributor. Almost all sales are thus internal to the network.
However my casual observation suggests that many sales are real sales. People who are signed up as distributors (but with no intention of selling stuff) regularly come in and buy product from other distributors.
Some of the clubs I visited asked for my name when I bought shakes - and the club manager explained that he took it because there was a “ten customer rule” but compliance with this was the exception rather than the norm - and many of the club managers were probably illiterate - so compliance was impossible. [Running a Herbalife club, sometimes successfully, is a job taken by more than a few illiterate Hispanics.]
If the Herbalife clubs in Queens were your guide (and they were for much of the New York Hedge Fund community) then even though the consumption was real consumption by repeat customers then Herbalife had a problem with the Amway safe harbour. Consumption was primarily internal.
There is evidence that the Queens clubs were unusual. I have seen clubs where almost all the consumption is by people who are not members. In China almost all consumption is by people who have not signed up as distributors (and the distributor qualification is hard). But the Queens clubs were visible in New York - and they are a very common form of club.
The whole issue of the 70 percent rule and the Queens clubs was made irrelevant by the Federal Court decision in the BurnLounge case.
BurnLounge
BurnLounge was a pyramid scheme selling music burning services and shut by the FTC. Much (probably the vast majority) of the consumption was internal - and hence an appeals court got do decide on internal consumption issues during the entire and intense Herbalife debate.
Here is the key extract:
BurnLounge and Arnold cite a passage from an FTC advisory letter, Exhibit 3 at trial, to argue that proof of internal consumption does not establish that BurnLounge was a pyramid. Read in its entirety, the relevant passage of the letter is consistent with the district court’s analysis. The relevant passage reads:
Much has been made of the personal, or internal, consumption issue in recent years. In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme. The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture. 
As discussed above, the rewards BurnLounge paid to Moguls were primarily in return for selling the right to participate in the money-making venture—the Mogul program. The merchandise in the packages was simply incidental.
And the court decided on that. Bluntly internal consumption is perfectly acceptable provided: "commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture".
The Herbalife clubs in Queens clearly meet this test. The consumption witnessed there - just like the consumption in the club in Israel - was for the purposes of losing weight and for the purposes of the social community that surrounded the club. The customers were not there for the right to participate in a money-making venture.
The poison in David Einhorn's questions has evaporated, over-ruled by the judges' decision in BurnLounge.
Between the Einhorn questions and the Ackman (Pershing Square) presentation
After David Einhorn asked his poisonous questions on the Herbalife conference call there was considerable speculation about what was Mr Einhorn's position in Herbalife and what other venemous material he might have.
Mr Einhorn clearly fed this speculation. He was expected to present at the Ira Sohn conference (a high-profile hedge fund event in New York) and the rumour was that he was going to present on an MLM. MLM usually stands for multi-level marketing scheme - and hence everyone assumed he was going to present on Herbalife.
Instead he presented on Martin Marietta - ticker MLM - and - on the day of the presentation Herbalife shares appreciated sharply. The story is told in Deal Book.
Mr Ackman's presentations
The Herbalife short-story exploded to the front page in late December 2012 when Bill Ackman (Pershing Square Capital) presented a massive short presentation over three hours. The presentation is still on the internet here:
This was done in as high a profile way as possible.
The Ira Sohn Conference is a charity event originally in New York and heavily Jewish - but now global and less obviously Jewish. The most famous hedge fund managers in the world give a “best ideas” presentation for an audience that pays many thousands of dollars per seat.
The conference is where David Einhorn presented his famous Lehman presentation (that was widely credited as being a precipitator of Lehman’s collapse).
Ackman called a “special” Ira Sohn conference (with a $25 million donation to the charity) and presented for three hours on Herbalife.
The core analysis is that Formula 1 [Herbalife's key protein shake product] is just another version of commodity protein-powder (just like many other brands) but they sell at premiums to those other brands. They are commodities as per this slide:


Indeed Mr Ackman goes further - and says that there is no real reason to buy the product:




But that ultimately (according to Mr Ackman) the reason why Herbalife sells so much product is that it is all about the “business opportunity”. To quote Mr Ackman's conclusion:




Bill Ackman then goes on for about 50 slides sampling huge amounts of “get rich” literature from recruiting distributors which pretty convincingly shows that some distributors make unrealistic claims. This literature does not come from the company, however many of the distributors making unrealistic claims are senior in the chain.
There are some things in this presentation that are flat-out-silly. For example Shane Dineen (a Texan analyst who seemed to have carriage of the stock for Pershing Square) asked rhetorically at one point if we knew whether there was a single legitimate end-consumer of Herbalife anywhere in the world.
This is clearly and patently wrong. But Bill Ackman described Shane Dineen's part of the presentation as being the result of a year's work.
Shane Dineen's suggestion that it is possible that there are no legitimate consumers of Herbalife is flat-out-inconsistent with the amount of research Bill Ackman has claimed to have done. It is dead easy to find legitimate consumers - and and they will proudly show you the before and after photos. You may not like the cult-like behaviour of many Herbalife consumers - but many will sell you on the product and they are not distributors. [This is a company where the customers who often have not signed a distribution agreement are rabid believers.]
Bluntly - either Pershing Square (Bill Ackman's fund) did not do as much work as they said or they are trying hard to fit into a pre-ordained thesis.
Ackman clearly states that most the sales are internal to the network and that the break-up (which the company made in response to David Einhorn) between “real” distributors and “discount purchasers” is phoney. He notes that there are easily available Herbalife products online (on Ebay) at a 35 percent discount - and hence it is insane to become a distributor for a 25 percent discount.




Essentially Pershing Square argues that it is a pyramid in fact and a pyramid at law.
[The fact that you meet plenty of people who become distributors for a 25 percent discount is not deemed worthy of attention here. They do it because they are members of a weight loss club (alcoholics anonymous for fat people) but as Mr Ackman does not see the community he does not see this as sane.]
Whatever - Bill Ackman wants to argue there is not sufficient real consumption - in other words there is an endless chain of recruitment and inventory loading. He quotes FTC guidance on inventory loading in this slide:




Bill Ackman also tries to refute the refund test in Amway:




He also has slides that point out that in some countries (e.g. El Salvador) there is no return policy. He also finds an affidavit of a customer who “threw out” $5000 worth of Herbalife. [There is now a return policy in El Salvador - but there may not have been when Mr Ackman wrote his slides.]
Mr Ackman's allegation is that the refund is much less generous than Amway - and that it is almost impossible to claim (too many onerous audit requirements) and therefore this must be an inventory loading pyramid.
We will get back to the refund rules later because the company amended them seemingly in response to the Ackman presentation.

An observation on returns and inventory loading

It was on returns I found the first clear chink in Bill Ackman’s presentation. Herbalife is vast (calculations below but about 6.6 percent of the size of McDonalds globally in terms of numbers of meals served). If there is really a lot of “inventory loading” there must be huge amounts of inventory somewhere looking for a home.
You would expect to find it on Craigs List and Ebay - in other words where people sell unwanted product - and if the volumes were as Bill Ackman suggests then it would be sold in distress on these formats.
It is not. It is almost non-existent on Craigs List and never sold at a sharp discount. There are lots of sellers on Ebay - but they all sell it with a “buy-it-now” price at a 35 percent discount and they have been selling it for years.
If you try to find out who the sellers are they will not tell you.
Here is a typical example - the sale of two tins of Formula 1 - free shipping in the USA:
The seller (“Zoomherbal”) has over 11 thousand bits of feedback and has sold this item almost 4000 times. They have probably sold 20 thousand Herbalife items. Selling 20 plus thousand items suggests that selling Herbalife products on Ebay is a business for “Zoomherbal”.
Zoomherbal” is breaching the rules of Herbalife because Herbalife does not like people selling online as it undermines the business of the existing distributors.
The 35 percent discount means that the distributor is almost certainly a fairly high-level distributor and buys it (say) a 50 percent discount - so they can do this and make money.
I have extensively looked on Ebay (and in various countries) but I cannot find any being sold in distress.
My conclusion: inventory loading does not happen.

The real response to Bill Ackman

Bill Ackman asked (rhetorically) why you would buy overpriced protein shakes at full price (or even a 25 percent discount) when cheaper stuff is available online and in supermarkets.
He does this many times
The answer is obvious. The product is not the protein shake. It is the community support for diet. In other words it is the club in Israel with the belly-dance fitness instructor, or the cafe (in Queens) or the Dance Club (in Malaysia) or the boot camp in Sydney or whatever. It is not substantially different to the question as to why would I buy a $10 drink at a bar when I can buy the same drink for $1 and drink it at home? Of course context matters.
The product Herbalife sells is the MLM - it is the community. It is the club. Not acknowledging that is the fundamental error in Mr Ackman’s presentation.
Indeed when he analyses the product as a "commodity" he misses the point. Someone once asked me if what Herbalife sold was hugs. Yes, and in some cases literally. I suspect it is the biggest hug seller in the world. When I look the distributors become genuine friends with their customers. They care about their customers. That is the power and enthusiasm that this company provides.

Lead selling scams

One new thing in Ackman’s Herbalife presentation (and where the taint against Herbalife is hard to make go away) is the prevalence of lead sellers in the network. Here Mr Ackman is on stronger ground.
The most offensive of these was a guy by the name of Shawn Dahl who had a business called “Income at home”. As the inventory loading thesis (which was the original core short-thesis) disappeared the stories about Shawn Dahl grew louder.
There is a reasonable press story here (probably sourced from people associated with Bill Ackman):
Dahl probably sent over 2 billion scam emails in the 2010-2012 - you were told about a woman who earned 7-10 thousand per month working from home. At my hedge fund we have a few email accounts we collect scam emails in (for the reason of finding stocks to short). We saw hundreds of “work from home” emails.
The emails and the first click did not identify Herbalife - but I gather that is where they led you. To get into the business opportunity you needed to buy leads, websites and other services from Dahl. The amounts of money fleeced by people who purchased these services were large and it was not difficult to find people who had been hurt by the lead sellers.
There were numerous stories in the press about the damage caused by lead sellers and there were three big lead sellers in the organization. The three big alleged lead sellers were Shawn Dahl, John Peterson and Doran Andry.
Two of those (Dahl, Peterson) were highly active. Doran Andry was a lead seller back in Mark Hughes day - and was and remains a very senior distributor (Chairmans Club) until this day. However he was successfully sued for fraud by some hurt distributors a decade ago and settled. To my knowledge he has not sold leads since. [All Ackman examples involving Doran Andry are over a decade old.]
Herbalife implemented a rule change in March 2013 (about three months after the Ackman presentation) such that anyone who sold leads was disqualified as a Herbalife distributor and lost their downline. Dahl and Peterson severed links with the company. Doran Andry remains silent (but still presumably collects checks from his downline). Dahl went to Nutrie another MLM (not very successfully it seems) and you can find his twitter feed here:
John Peterson shot himself in the roof of the mouth (to a surprising amount of press coverage).
When the company banned lead sellers it said that it would have a low single-digit negative effect on sales. You can’t see it in the sales numbers during the following three quarters. However sales have been weak now for three quarters and some shorts have blamed the weak sales on this change. [I do not think so - and I have a demonstrable explanation of the weak sales below.]

The rules for Herbalife clubs

In Pershing Square's presentation much is made on the seemingly perverse rules for setting up Herbalife clubs and how dowdy they all seem. Here are photos he has of clubs (and which do not seem unfair for clubs in low income areas).






My experience is that in poorer areas clubs look like this. In richer areas they can look more like this one (which is in Delaware and online).




But in both cases there is no signage and the purpose of the club is disguised.
Ackman indicates the following and seems to indicate that (a) it is entirely consistent with the rules of Herbalife and (b) that it is nefarious:




The company has been fairly clear why it is like that. The explanation is that for a MLM it is important for distributors to protect the second sale.
Avon (famously) opened stores (under Andrea Jung as CEO) and it was a disaster. The issue is that if a woman knocking on doors gets a woman to buy Avon she will likely get a further sale out of it later. Indeed the job of an Avon lady is to build up a book of repeat customers - and the job of a Herbalife distributor is similarly to build up a book of repeat customers.
Alas if the customer can buy it from a store that undermines the direct selling model. [You can't get a second sale if the customer can easily go elsewhere.]
To protect the business of their distributors the company prohibits anyone from opening a store that is identifiable as a Herbalife store (except to people in enough know to recognise the colours), or to sell it online (which is why the Ebay people I have approached are evasive).
That said - the store rules have been a source of short-conspiracy thesis ever since. The rules are clearly to protect the business of existing distributors but if you do not understand the underlying business rationalle the rules look perverse. The company has - in my observation - made consistent moves entirely to protect the business of existing distributors – and many seemingly perverse company moves can be understood only in that context.
Bill Ackman’s later presentations
Bill Ackman has followed up his original presentations with several more.
One is a documentary interviewing several Herbalife victims. It turns out that every victim was a victim of Shawn Dahl and the money they lost substantially went to Shawn Dahl rather than to Herbalife. Shawn Dahl's downline was (at most) a low single-digit percentage of Herbalife.
Another is a study arguing Herbalife’s (fast growing) business in China is illegal under Chinese law.
This is an area where I feel quite qualified to comment. In China I visited three Herbalife distributors, two in Beijing without permission from the company and without giving the company advance notice and one in Dongguan with guidance from the company. I travelled with a translator quite expert in the relevant Chinese rules (the translator had previously spent some time sceptically researching Nu Skin's rather dodgy China operations). [My China notes are below.]

Full refunds and the change in short-thesis from “it's a pyramid in fact” to “it's a pyramid at law”

The response to the original short-thesis was to (a) ban lead-sellers as discussed, and (b) implement the “gold standard” for refunds which offers a full 100 percent refund including postage for all sellers on unopened product and for opened starter kits. The refund rules are in the top of all boxes sold by Herbalife and in the US are sent in English and Spanish.
This was to prove that inventory loading did not happen and it could not be a pyramid in the sense originally described by Bill Ackman.
There have been some quibbles about this refund. It does not include postage paid by the customer in receiving the product and several people have tried to argue that this is a major profit centre for the company. [This postage is not paid in a large proportion of non-American-non-Chinese sales - as these are field sales - discussed below.] However you count it though the refund is more generous than required under the Amway safe-harbour provision - and the evidence is that it is honoured scrupulously on the ground.
As a result there was a change in the short-thesis from it's a pyramid in fact (proven by inventory loading and having to recruit more victims to buy more inventory) to it's a pyramid at law because all the customers are insiders - that is members of the club - and that all sales are to people who are legally signed up as distributors.
In other words Bill Ackman retreated to David Einhorn’s original (and poisonous) questions.
The company has always denied that a majority of sales are to people who have signed up as a distributor but (until very recently) they did not give definitive data and even that data came from a commissioned survey and not from their own distributors. As stated compliance with distributor rules about how the distributors should report sales to external customers is thin (in part because many of the distributors are illiterate).
The company press release that gave the critical data out is here:
The release is several years late and vague - and as stated the source of the data was Herbalife-sponsored surveys of its U.S. customers and Members that were undertaken by the market research firms Lieberman Research Worldwide and The Nielsen Company, B.V. This looked rather thin and the fact they needed to rely on third-party research data rather than their own extensive (Oracle) based system tells you that compliance by their distributors is far from total. [In visiting various distributors I can assure you I have seen the full-range from utter compliance to total disregard of the 70 percent rule.]
Whatever, the 70 percent rule now looks like it is unnecessary because the BurnLounge case made it clear that the question was really whether the purchases are not merely incidental to the business opportunity.

How big is Herbalife by sales - and comparisons to numbers of members

When Herbalife quotes its quarterly numbers it quotes them in dollars and also in “volume points”. Volume points are how status (hence commission) in the Herbalife structure is determined. All products (except the business starter kit) have a certain number of volume points attached and that number is independent of the price of the product or which country it is sold in. [The business starter kit has no volume points attached because payment to the upline for selling business starter kits would clearly be a “recruiting reward” as per the above-mentioned Koscot case.]
A tin of Formula 1 is the same number of “volume points” in every country in the world.
I did the calculation in the second quarter of 2014. Volume points have shrunk somewhat since then (and I will explain why below). But this gives a reasonable scale for the business.


Global volume points were 1.43 billion for the quarter. This is the highest rate ever - but annualizes at 5.72 billion.
32 percent of sales are Formula 1 [a number that comes from the Bill Ackman slide above].
This suggests that annual Formula 1 sales are 1.83 billion volume points (annualised).
These are 750 gram tins of Formula 1 [the tin comes in two sizes - the other being 550 grams].




The tins represent 32.75 volume points (as per this linked brochure).
The suggested meal (and the ones that I have been served in clubs) is a 25 gram scoop of Formula 1 blended with skim milk. [If you do not want to use milk use more Formula 1 but taste is compromised.]
This suggests that a tin contains 30 “meals” or enough for a month. [This is consistent with Herbalife user blogs…]
It is not quite a meal equals a volume point - but a meal is 1.08 volume points.
That suggests that annual Formula 1 meals sold is about 1.7 billion or 4.6 million per day.
That is an astounding number. McDonalds famously serves about 70 million meals per day - so it is 6.6% the size of McDonalds in terms of meals served. Moreover there are 3.7 million distributors but only 340 thousand sales leaders.
If ALL the distributors had one meal per day every day of the year then you still would not account for volume.
Moreover many distributors are lapsed or have very low volumes. So in order for it to be majority sold to Herbalife distributors [and hence be a “pyramid at law” there have to be a vast number of distributors who consume multiple meals per day of Herbalife. Alternatively they must have enormous stockpiles in their garages.]
Distributors who allegedly consume multiple meals a day
The calculation I make above – showing that to be a pyramid most the distributors need to consume multiple meals a day has – to some extent – become the short case.
Indeed, this is what Bill Ackman alleged in one of his later presentations that focuses on “Club 100”. I think implausibly the short-selling crowd came up with the idea that the distributors were consuming seven plus meals per day.
Club 100 - an introduction
There is a kind of nice (and rather glitzy) video about clubs put out by the company - and it turns out that about half the clubs are Club 100 members [visible in logos on the wall and the like]. Club 100 is clearly a big thing.
They also have training programs, and it is through the training programs that shorts have alleged that people eat up to seven Herbalife meals a day for reasons entirely concerned with the business opportunity. These training programs have become the means by which shorts think Herbalife fails on the test defined in the Burn Lounge case.
I am not making this up.
You need only look at a SeekingAlpha article by Christine Richards. Christine Richards is a former journalist who worked for a hedge-fund-research shop called The Indago Group. She is also the hagiographer of Bill Ackman. Richard has since left the Indago to start her own firm (Orion Research). By repute (though I suspect it is not true) it was her who planted the Einhorn questions.
Here is the Christine Richard article (which had a surprisingly negative effect on the stock). I quote it nearly in full because it is the entirety of Bill Ackman’s new thesis (and the now 650 comments on the article tell you the ardour at with which all this stuff is debated):

Herbalife: Who's Consuming All Those Shakes? And Why...

Summary

  • On the ground investigative research into Herbalife's nutrition clubs suggests they're not what they seem.
  • Club 100's quota system raises questions about the true nature of shake consumption.
  • The motivation for sales in an MLM matters per recent rulings; that could be a factor in considering Herbalife's business.
What's the truth behind Herbalife's Nutrition Club business? If you read thisrecent Reuters article, based on interviews the reporters did with people they encountered at ten Nutrition Clubs, you probably came away believing these Clubs are a force for good in the Hispanic community. I think the reporters were deceived by what they saw and heard, and I base this statement on several years of researching these Clubs, not just in the U.S. and Puerto Rico, but Mexico, Colombia, Venezuela and Brazil. Walk into an Herbalife Nutrition Club and you enter into a charade created by an elaborate and cynical "training" system that turns distributors and their family members and friends into conscripted consumers. Let me explain how I came to that conclusion.
I started visiting Herbalife Nutrition Clubs in 2011 as part of a project on behalf of a number of hedge fund managers who were trying to determine whether Herbalife Ltd. (NYSE:HLF) was a legitimate business or, as some critics alleged, a pyramid scheme: an unsustainable and illegal business model in which participants make money primarily by enrolling new participants in the business.
To help answer this question, I decided to take a close look at Herbalife's Nutrition Club network, which was (and still is) fueling the company's growth. These Clubs, which serve single portions of the company's products such as its Formula One protein shake, were popular with a surprising demographic in the U.S.: Hispanic immigrants in low-income neighborhoods.
I started my research by visiting the Corona neighborhood of Queens, mapping out the Clubs surrounding Junction Boulevard and Roosevelt Avenue. Many were hidden away in undesirable retail locations, down alleys and in the basement level of strip malls, with shabby looking storefronts and interiors hidden by green curtains. A handful, however, were more prominent and had signs (in Spanish) that expressed boundless optimism: "A Beautiful Life," "A Better World," etc. But one thing I knew for sure was that there were far too many of these Clubs to make any economic sense: I found 26 within a few blocks of the Junction Boulevard subway stop.
Shortly after, I started visiting Nutrition Clubs with hedge fund clients. Herbalife was under no particular scrutiny then, which was a good thing, because we certainly didn't blend in at the largely Ecuadorean-run Clubs we were visiting: a middle-aged white woman, with a notebook and a printed Google map of the neighborhood, and a hedge fund analyst, invariably "dressed down" in baseball cap and extraordinarily expensive loafers. [John's note: baseball cap and loafers sounds very like David Einhorn but I have been told that it probably is not.] We stood out like two Jehovah's Witnesses canvassing the neighborhood - and that was before we opened our mouths. On one of my first visits with an analyst, I warned him that my high school Spanish was a bit rusty and asked if he spoke any. Alas, he replied that he had studied Latin in school.
During our visits, we identified ourselves as analysts seeking to better understand the operations of this publicly traded company. I think most people suspected we were from Herbalife's compliance department, checking to see whether they were following the company's endless and often bizarre rules: no Herbalife signs visible from the street, all doors and windows covered to prevent visibility into the Club, no "Open" or "Closed" signs, no selling full containers of products, etc. (These rules alone raised serious doubts in my mind about how a distributor could hope to succeed.)
The people we met in the Clubs were without exception friendly and tolerant of the communication barrier. They believed Herbalife was transforming their lives from paid-under-the-table kitchen help and construction workers into full-fledged achievers of the American Dream. They talked about Nutrition Clubs as a route to the prestigious and lucrative Herbalife "President's Team." I left every Club I visited hoping that somehow this business would work out for them.
Many people dismiss the harm done by pyramid schemes, downplaying it with comparisons to companies that sell us things that aren't very good for us: cigarettes and liquor, fast food and lottery tickets, etc. But this is a spurious comparison. Nobody who smokes thinks it's good for them and nobody who buys a lottery ticket thinks the odds are in their favor.
Meanwhile, deceptive business opportunities reshape lives around lies, making deep inroads into a person's psyche, changing whom they interact with and whom they shut out, how they spend their waking hours, and how they dream about and build for their future. Robert Fitzpatrick, an expert in analyzing business opportunity fraud, had concluded that Herbalife's business was based on deception long before I began my research. He summed it up in an email he sent me: "Herbalife has entered the fabric of Main Street. It has tampered with the souls of millions of people."
So, what was Herbalife doing with these souls in this hardworking, immigrant community in Queens? Was it delivering on its promise of a better life for the people who attended and ran these Clubs? If so, there was something extraordinary at work here: a company that had found a way to engage those at the bottom of the economic ladder, people confronted with daily hardships most Americans can only imagine, and through its products and business opportunity was steering them toward better health and financial security.
For some, Herbalife clearly hadn't delivered on this promise, as evidenced by the dozens of shuttered or moribund Nutrition Clubs I saw, testaments to someone's failed dream - and to my suspicion that these Clubs were a place for disillusioned (and broke) Herbalife distributors to dump the product they'd been forced to buy in their pursuit of the "business opportunity."
But I also found active Clubs and watched as people came through the door, handed over $5, and drank servings of the products. I watched Club operators record each person's name and proudly explain that these customers came each and every day - they were frequently described as "socios" (the Spanish word for partner) in this grand Herbalife vision of health and financial freedom. Yet, there was always a hint of staging to these interactions. More than once I asked a person visiting a Club if he or she worked there or was an Herbalife distributor, and the answer, from a person with a limited English vocabulary, was jarring: "No. I just come here to consume." Consume?
One morning I visited a number of Clubs with a well-known hedge fund manager -- a positive sign that interest in our research was trickling upward. Hedge fund types tend to be health and body conscious and while most were curious to see the products, they baulked at actually consuming them. "You can never be too careful about what you put into your body." This meant that when the host's back was turned, I frequently switched the cups and ended up drinking both servings. But, on this day, my companion was 100% into the research; he gamely consumed at every club and complimented the host on the preparation. Among the Clubs we visited was one enthusiastically staffed by a husband and wife team, who phoned their high school-age son to come and translate. All three were distributors and had put the family savings, plus money borrowed from relatives, into the Club.
On our final stop, we climbed a creaky flight of stairs to the second floor where -- expecting to find a locked door or a deserted Club -- we entered a tiny room in which about a dozen men in bulky hoodies and heavy work boots sat silently on folding chairs, eyes fixed straight ahead, Formula One shakes in hand. These men were vaguely familiar, the faces one glimpses hauling debris out of buildings undergoing renovations, bussing dishes in the kitchens of restaurants, and flying through treacherous Manhattan traffic on rickety bicycles, delivering food. They certainly weren't overweight and didn't appear to have the luxury of the time or money required to consume expensive nutritional shakes in a Club. But nevertheless, here they were, doing what Herbalife claimed so many in the Hispanic community loved to do: gather in a social setting to enjoy good nutrition.
The host had a bright - though slightly bemused - smile for us. Everyone else could have been waiting for a bus; oblivious to a cartoon blasting in Spanish on an overhead TV, the men ignored one another and avoided eye contact with us.
With every seat taken, we had to stand, drinking our third Formula One shake, Aloe Water and Herbal Tea of the morning, a good 40 to 50 fluid ounces each into our research. A few minutes later, in search of the bathroom, we were directed into a large adjoining room where, the host explained, the group held regular training meetings. It was empty, lights out, but he assured us that it filled up twice a week with all of the distributors in the neighborhood who were learning the business.
On our way back down the stairs, I asked my companion if he thought people were really there because they wanted to drink a Formula One shake.
"No."
So what were they doing?
Herbalife claims that Nutrition Club visitors are genuine customers seeking better health and are drawn to the Clubs because they lack the economic resources to buy an entire container of Formula One, so instead they're paying a few dollars a day to consume single portions of the products. These consumers prove that Herbalife is not a pyramid scheme, according to the company, because, after all, if the sales in Nutrition Clubs are to real customers, then the commissions Herbalife pays on the purchase of those products to the distributors operating the Clubs are linked primarily to retail sales, not to recruitment and qualification.
Were these men grudgingly consuming shakes in a tiny Club in Queens examples of the customers that proved Herbalife was not a pyramid scheme?
The answer only became clear later, when I was hired full-time to study Herbalife by another hedge fund manager, Bill Ackman, whom I met as a reporter covering his short position on a bond insurance company called MBIA. That was a seven-year story, and you can read a book about it here. MBIA, which insured bonds backed by risky mortgages and magically turned them into triple-A-rated securities in the run-up to the 2008 credit crisis, was a company that, like Herbalife, one might argue was in the too-good-to-be-true business.
Soon after I began work for Ackman, I came across the first "Club 100" Nutrition Club on the Internet. The group, also known by its Spanish name "Club Cien," appeared to make up a vast network of Herbalife Nutrition Clubs in the Hispanic community in the U.S. and across Latin America. I found a Yahoo message board used by Club 100 members in Venezuela describing the rules for visiting an Herbalife Nutrition Club.
Rules for customers?
I ran parts of the text through Google Translate and out spilled a cryptic and clunky description of how a person visiting a Club is supposed to act:
"AVOID MAJOR GROUPS OF 5 PEOPLE BY CLUB TO VISIT."
"AVOID THE USE OF UNAUTHORIZED PHOTO CAMERAS."
"AVOID TALKING TO CONSUMERS CLUB, UNLESS YOU ASK THE HOST."
"CAN BE VIEWED ONLY CLUBS THAT ARE 25 AND MORE ACTIVE IN THE SYSTEM CERTIFICATION WITH SEALS."
"REMEMBER THE RULE: ALWAYS GOOD ATTITUDE: SILENT, KIND, ASSIGN CONSUMERS CHAIRS. IF TESTIMONY TO HELP AND GIVE WHAT YOU ASK, SEEK TO AVOID SPECIFIC PRODUCTS OR FLAVORS , WITH QUESTIONS TO AVOID HOST STOP OR WHILE STUDENTS ARE RESPONDING TO CONSUMERS."
It was stunning.
Since when are real customers told to remain silent and instructed not to ask for certain flavors? But, if the people visiting Nutrition Clubs weren't real customers, who were they?
To find out, we hired freelance reporters and private investigators to visit Club 100 Clubs in major cities in the U.S. and Puerto Rico, then in Mexico, Colombia, Venezuela and Brazil. There was a great deal of secrecy surrounding Club 100's business methods. We were often told that only those who signed up with Herbalife through Club 100 were allowed to know how the plan operated. Even those already enrolled in the group were kept in the dark about much of its operation and were told they would be informed about the next phase only after completing the current phase. We signed up and joined Club 100 agreeing to do exactly what we were told was necessary to succeed. Our investigators uncovered a business that turns those seeking to open Nutrition Clubs - along with family members and friends helping them pursue their dream - into conscripted consumers by forcing aspiring Club owners through a series of tasks: touring Clubs and paying to consume at each one, working for free in an upline distributor's Club while being required to consume on the job, and practicing making hundreds of shakes, which family members are required to buy and consume. Trainees also are required to create a story or testimonial about the benefits of the products on their health and to tell this story numerous times to potential recruits in order to graduate. Only those who complete all these tasks, which are tracked and verified by upline distributors on an official form, are certified to open their own Clubs.
The promised rewards are enticing. Those who follow Club 100's rules are told they will reach the President's Team where they can expect to earn hundreds of thousands of dollars a year for the rest of their lives. Herbalife's own data suggests that fewer than 1-in-10,000 distributors will reach the President's Team - but these nearly impossible odds are rarely if ever disclosed to recruits.
Instead, Herbalife trainers (i.e. recruiters) play on desperation and disappointment. In the U.S. we recorded training sessions where messages like the following were directed at undocumented workers for whom the American Dream had proved elusive:
"If you take it (the certification course), you'll get good consequences. If you leave it, I don't know how life will go for you, because how long have you been in this country? 10? 15? 20 years? Another 5, 10 or 20 years will go by and you'll continue in the same spot. Because if in another 5 or 10 years you haven't achieved what you expected in this country, you're not going to achieve it."
On July 22, 2014, as part of Bill Ackman's presentation on Herbalife entitled "The Big Lie," I detailed our findings about Club 100. While investors appear to have mostly ignored our findings - on the company's second quarter earnings conference call a few days later, not a single analyst asked about Club 100 - I believe it is key to understanding the character of Herbalife's business, and, ultimately to forecasting the company's fate.
Herbalife aggressively sells its "business opportunity" - but requires lots of coerced consuming to access it. Our team's months of research in the U.S., Puerto Rico, Mexico, Colombia and Venezuela showed that a distributor diligently attempting the certification process - the first step in Club 100's complex and secretive plan - would consume or cause other people to consume about 632 shakes over a three-month period. Here's how:
Trainees are expected to work out of an upline distributor's Club. As part of this unpaid internship, they are expected to consume as often as twice a day - AM and PM shifts.
180 Shakes Consumed
Trainees are required to go on tours of eight Nutrition Clubs and to pay for and consume at each Club.
8 Shakes Consumed
Trainees are often expected to consume at classes and other mandatory events. Let's assume a trainee attends three weekly events for 12 weeks.
36 Shakes Consumed
Trainees are required to make 100 shakes as part of the mandatory shake training requirement. Distributors are likely to offer free samples (which they pay for) or cajole friends and family members to come into the Club to pay for and consume these practice shakes.
100 Shakes Consumed
Trainees are required to take a test proving they can invite one paying consumer into a Club every half hour for four hours
8 Shakes Consumed
Trainees are expected to recruit 10 individuals who will act as regular attendees of an upline distributor's Club for one month.
300 Shakes Consumed
Total Shakes Consumed
632*


*The actual numbers vary quite a bit because there is plenty of room for trainers to impose inconsistent and repetitive requirements, but I believe these estimates are realistic.
That averages out to seven shakes every single day for every single recruit (632 / 90 days), which adds up to millions of shakes annually! Again, if all this consumption was legitimate, Herbalife would be a reputable and impressive business. But it's not - it's part of a nefarious plan to bring low-income distributors (and their friends and family) into Clubs to share the cost of admission to this deceptively promoted American Dream.
Some claim that the motivation of these customers doesn't matter - consumption is consumption. But the courts and regulators see it differently.
Since the beginning of this Wall Street battle, the Direct Selling Association, which represents Herbalife and other MLMs, has pointed reporters and analysts interested in evaluating whether Herbalife is a pyramid scheme to a 2004 advisory letter issued by the FTC on the question of distributor consumption, which states: "Much has been made of the personal, or internal, consumption issue in recent years. In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme."
Herbalife has leaned heavily on this letter and, in fact, the company now calls its distributors "members."
Yet, on June 2, 2014, an appeals panel upheld a decision that BurnLounge, an MLM that sold downloadable music, was a pyramid scheme. BurnLounge had appealed an earlier ruling, in part, by citing the 2004 letter and arguing that its distributors should be considered customers. The court rejected the argument and pointed back to the 2004 letter, stressing that the relevant passage on internal consumption must be read in its entirety: "The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture."
In other words, motivation does, in fact, matter. Regulators and courts want to know why people are consuming a product. Are they consuming it because they like it and would choose it over other products based on price, quality, brand, the overall experience, etc.? Or, is the real motivation behind the purchase of a product "the right to participate in a money-making venture"?
The Club 100 system is fiendishly clever. It ensnares countless people all over the world in Herbalife's web, drains them of their time and money and, best of all (from Herbalife's point of view), results in a great deal of consumption of Herbalife's products, which makes it much harder for regulators to detect and shut down this sophisticated pyramid scheme. Finally, it is clear why we don't see very much Herbalife product stacked in garages or dumped on eBay, and why so little is returned to the company. Most of the product is indeed consumed, but not, as Herbalife would have you believe, by real customers but rather by those pursuing quotas established by the company's top distributors for people they deceive into pursuing a false promise of the American Dream.
Shut out by language and cultural barriers, by suspicion that we were compliance officers or immigration officials posing as Wall Street researchers, and, most importantly, by a system that created its own illusion, it would be three years before I understood it. Now, thinking back on that morning in Queens, I understand why the men crowded into that second-story Nutrition Club in Queens appeared to be such unconvincing customers - it's because they weren't real customers. Instead, they were spending money they couldn't spare to drink a shake they probably didn't like to lose fat they didn't have in order to pursue (or help a friend or family member pursue) a "certification" for a "business opportunity" that doesn't exist for the overwhelming majority of people. They weren't customers in any traditional sense of the word; rather, they were paying the price of admission to a fraudulently promoted business, one shake at a time.
Christine Richard is the President of Orion Research LLC, which does investigative research for investors. She is a former reporter with Bloomberg News and Dow Jones and the author of Confidence Game: How Bill Ackman Called Wall Street's Bluff (Wiley, 2010). Pershing Square Capital Management, which has a short position on Herbalife, is a client of Orion Research LLC.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author does not take positions in companies she researches. Pershing Square Capital Management, which has a short position on Herbalife, is a client of Orion Research LLC.
The idea that there are a huge number of people paying to drink 5-7 plus protein shakes a day is - in my opinion - ludicrous. I challenge you to do that (as you would almost certainly throw up). It is also deeply contrary to what I saw on the ground. I saw real and regular consumers.
I don't know how to react here... Christine Richard can't speak their language, wants to ignore what they tell her when asked directly, spend three years researching and came to the conclusion that literally millions of people drink enough Herbalife shakes to throw up on a daily basis because they have been fooled into believing it is a route to prosperity.
The illusion here – and it has been repeated to me by other shorts – is that there is a fraud here that has taken in millions of people who are uneducated but we – white-middle-class liberals – can see right through it no matter what these people say.
It is the line of someone who sees facts-on-the-ground that differ from their thesis and distorts those facts to come up with a new thesis.
One Latino correspondent in Miami was so offended by this he started sending me pictures of clubs in Little Havana. Here goes.


The club in question is run by the guy on the left’s wife [i.e. the wife of the senior policeman]. The club has about 280 visitors a day (which makes it an acceptable business) about 40 of whom are uniformed cops. The club also has a cycling group associated with it. Ray [the guy on the right] told me it was an alternative to the policeman’s sedentary with doughnuts diet.
This - with real consumer doing a shake a day - is the model on the ground. It is a repeated pattern, easy to find.
Clubs with middle class customers are rarer – but they are generally pretty nice.
Clubs entirely in poverty struck neighbourhoods reflect their community. The clubs in Queens are a fairly gruesome affair. You need about 60 visitors a day to make minimum wage and the clubs get 50-70. You can easily find people who work long hours for less than minimum wage.
When you talk to these people they think it better than working in a fast-food joint. They socialize with their friends, they think they are doing well, often they have young kids playing in the back of the club. The more middle class the area the larger the clubs tend to be (but some clubs in Malaysia are huge). The club above (with the police) is apparently 240-280 visitors a day - which winds up being far better than minimum wage. The cops believe in the business opportunity - without stating that they will get rich from it. However as most hedge fund types have visited only Queens (if they have visited any) they see only the gruesome.
Clubs in China
Multi-level marketing schemes in China are illegal. Direct selling organisations are not. The differences are subtle [is Avon a direct seller, or a multi-level marketer?]. But the origin of the difference is not subtle. In China hierarchical structures involving lots of people not under the direct control of the Party are illegal. Strangely Bill Ackman's China presentation presented the Chinese MLM laws as about consumer protection whereas they are about Party protection. [If consumer protection were so important why are most Chinese correctly convinced their food chain is compromised?]
Anyway I visited Herbalife distributors in Beijing without permission from the company, sent my notes - including some concerns - to the company and some large shareholders - and then with permission of the company went to visit distributors in Dongguan (in the Pearl River Delta). The Dongguan visit was on the same day as my visit to Hanergy in Heyuan. [Link.]
The distributors I was taken to in Dongguan were particularly successful (the most successful in the area) but apart from that the features were mostly unchanged between Beijing and the South.
Here are my contemporaneous notes of my trip to two distributors in outer Beijing.
(a). The price point for a Herbalife diet plan is a about 2X America. This fits with my observation that everything is overpriced in China and the currency is just flat wrong - but it is kind of disconcerting.
In America Herbalife meals are cheaper than the meals they replace. A $5 stop at a club to drink all three (aloe drink, tea, shake) is cheaper than getting equivalently full at Burger King. That is emphatically not true in China - where the meals are maybe 5X as expensive as the meals they replace and if you are middle income white-collar in Beijing then the expense of a two meal per day replacement diet is large compared to income. And if you are blue collar working class in Beijing it is 100 percent of income. This means that the product is not for the working class in China and it limits its size.
I should note that this was the thing about the Beijing stores I found most upsetting. In American as in Israel and in most other markets Herbalife is cheaper than the meal it replaces. Bill Ackman (falsely) describes it as expensive and ripping off the poor. But Herbalife clubs - rather than a gym and personal trainer - are the way the poor get in shape. And it is a very cheap way.
Pricing in China limits that market. Herbalife is necessarily a middle income product.
(b). The second observation is that the clubs are quite different from the Mexico/USA clubs even though the people there thought the model came from Mexico. In the Mexico/USA clubs you walk through the door and drink "all three". It is a sit-around-and-chat model. The clubs are pseudo cafes - but you swap coffee for diet products. In this case none of the three clubs would sell me a single shake. Indeed it was very difficult to get them to sell me anything at all. What they wanted to do - and it seems to be standard - is that they measure your fat and other body measurements (standard electro-conductivity scales) and then put you on a diet plan. The diet plan is 7 days - but they then try to renew you for 90 days and then - presumably at a lower intensity - for a longer time thereafter.
Here - for the record - is a photo of me getting measured up for a diet plan (which you might unkindly note that I need).




And this is the club which actually says Nutrition Club in English... [This club is about 15 kilometres from central Beijing.]






China is still a daily consumption model - but there was less direct oversight of the daily consumption. The idea of buying a cannister of diet shake was sort of foreign to them. I did so though and I paid full retail - 550gram cannister for 329 Yuan (52 USD). This is a $26 retail price normally. And they were deeply reluctant to sell it to me.
(c). Both clubs were well appointed. The name Herbalife did not appear on the door (as per usual) and the staff were flat-out good looking. Young, groovy well dressed. This is contrast with the Hispanic clubs in New York where the owners are usually poverty struck by New York standards. These people would not look out of place in middle class Sydney - and indeed would be considered good looking.


(d). We asked how many customers they had. Both said 40 – and at the time I was not sure I believed them. [I should note that 40 turns out to be a magic number – and I probably do believe them in retrospect.] In the time we were there (Sunday, good weather) a couple of customers came through both shops but did not stop around.
(e). There was almost no inventory at the stores. They told us that the ordering process is that the customers have a number - and they order online. The product is delivered direct to the customer and the company has a warehouse in the major cities so it is next day delivery. The lack of inventory is kind of important because if this is the model it is 100% safe against being called a pyramid under US law (as the sales are clearly to end customers and there is no inventory loading...)
I cannot stress how important this is. There is no inventory anywhere in the chain that is not a company owned warehouse in China. The company is completely immune to a pyramid allegation in China - and if this were the model in the US there would be no possible allegation either. The Ackman assertion that the entire global business is a pyramid is falsified by this fact. The fastest growing part of it has no pyramid features at all.
(f). At one stage we asked how much you [the distributor] got when a customer placed an order - and it seemed to be between 15 and 30 percent of the sale. [They showed us a remuneration scale I did not understand - but strangely all the distributor cuts seemed below the US. For instance they told us the cheapest a distributor can buy it is 30% discount - but outside China a sales leader can buy it at a 50% discount.
We later discovered that the direct selling rules in China limit the retail margin to 30 percent - but everywhere outside China the retailers doing serious volume (i.e. greater than about $4000 worth per year) buy the product at a 50 percent discount. The company does a few things which seem to circumvent this rule - and it pays other commissions for "activities".
The second club we saw was in a Greenland development. Greenland is a particularly delusional listed Chinese property developer.
The building was five years old and probably about half vacant. The downstairs was never tenanted and was falling apart. Here are few photos.
First the building...


This was a typical downstairs tenancy.




Like most heavily vacant buildings in China doors featured heavy duty bicycle locks. [I have seen hundreds of such locks...]




But there was an occupied section and the "club" was in a small room on the fifth floor. Again there was limited signage on the door - but your chance of finding this club from the street was approximately zero.
Still there were customers who visited whilst I was there.
However this was a not a club where people sat down and had shakes and chatted. Instead the club clearly organised exercise activities. For example it took people hiking in the hills outside Beijing. In China this is an entirely saleable proposition... there are no hiking clubs in Beijing - and clubs per-se are very hard to organise within Party structures.
There were pictures of activities on the walls. The Dongguan club I went to had pictures of going to the beach - which looked very attractive and was about 70 km away. A bus would be hired. The company paid for these activities (supplementing the 30 percent retail commission that was paid) and senior distributors are paid more. You could - if you were aggressive about it - construe these payments as breaking the direct selling law in China. But I do not think that would be the right interpretation.
The organisation is extremely strict on how these activities are organised - because I think they are the main selling point - but they are also the point at which the club gets together large numbers of people (and hence runs the risk of offending the Party). The Dongguan club (and the management in Dongguan who I met) told me they had to ensure that all activities were limited to 40 people - a number which did not offend the Party. It was clear that any and all rules about gathering of people were the rules they were most keen to observe.
Strangely both Beijing clubs we visited claimed they had 40 members. 40 members was a number that was repeated in Donnguan - and seems to be the limit of the number that you can take on one of your activities. We did the maths and with 40 members you make quite a good living in China relative the alternatives available. [The people who ran the second club had previously been hair clippers and talked about life with scissors.]
The Dongguan club differed from the Beijing clubs in a couple of respects. Firstly it was more successful - and the person claimed about 130 members - but told us that he never organised a group of more than 40. [It was the most successful club around and the company chose it for us.] Moreover it used to be in a cafe - so it had a bar at which people could and did sit around drinking shakes. This is not like clubs in other countries though - the number of people who drank shakes there would never have exceeded half a dozen. The shakes were mostly drunk at home. The owner told us the bar was not installed by him but the previous tenant at the shop.


The club however would accept deliveries on behalf of its customers - and these were placed in lockers at the club. The customer's name was written on them. The distributor held no inventory.
Here are the lockers...



And here, inside the locker is customer product with their name on it. This product was opened - and the customer came in irregularly and had a shake with the owner and/or some friends.


As a summary - the business in China is not in the long-run as attractive as the business in say Israel - because it is much harder to provide the social aspect and a sense of community in a country where large gatherings tend to raise the ire of authorities. But the market is huge (there are millions of overweight people - the victims of having four grandparents per grandkid). And there is plenty of growth left.
Alas it is also - because it is relatively expensive - not a product for the very poor in China. This probably eliminates half or more of the potential market in China.
The remuneration structure
One of the more controversial things about Herbalife is the remuneration structure which makes a few distributors very rich and can remunerate a distributor down an endless chain of recruits. In other words if A recruits B recruits C recruits D recruits E all the way down to Z it is almost inconceiveable that A has anything to do with Z - but A is (sometimes) entitled to a proportion of purchases by Z or even purchases by Z's customers.
The endless remuneration scheme is tied to get-rich claims by some distributors and is argued by Ackman and his supporters to be evidence that this is a pyramid scheme designed to enrich the people at the very top.
Alas - and I have proved comprehensively - the key Ackman researchers did not understand the remuneration scheme. 
I posed a question and gave people about ten days to answer it. This was the question.
Imagine you were the very first Herbalife distributor and you recruited three people and they - eventually and through their downline - recruited the millions of people who now consume and/or distribute Herbalife.
And also presume you did nothing else for the rest of your career. You just sat there and collected the "recruitment rewards" or the "royalty checks".
Roughly how big would your income be now? And from how many levels would you be collecting your income?
Surprisingly nobody except some distributors who read my blog got the answer. [The distributors were fast and accurate.] Cristine Richards - Ackman's key researcher - was comprehensively wrong. Here is the answer I gave:

If you are a base level distributor you buy the product at a discount of up to 42 percent. You sell it at retail. You make a margin.
At some point you become a sales leader. A sales leader is entitled to buy it at up to 50 percent discount. You can NEVER buy the product at a higher discount than 50 percent.
But the sales leader is entitled to a royalty. The royalty is paid three levels deep. A recruits B recruits C recruits D recruits E then A is entitled to 5% of BCD but not E's sales. B is entititled to 5% of CDE sales. That way 15 percent more is paid out.
This you are always entitled to - three levels deep.
After that there is a "production bonus". These are up to 7% of sales based on your level. However if someone in your down-line earns 2% production bonus then you are only entitled to 5%. And when your down-line is long and successful enough the entire 7% will be earned below you. You will be blocked and receive no income.
After that and if you are senior enough you may receive the Mark Hughes Bonus - typically 1% of all sales paid infinitely deep in the sales structure. However if someone in the Chairman's Club is below you (and this happens) then you get blocked on that too. So you will receive no Mark Hughes bonus.
The person I describe could never be in the Chairman's Club (to do that you need 5 people below you to make a certain level) but someone who was very early and has done almost no recruiting will almost entirely be blocked on the Chairman's Club as well.
So lets calculate the answer...
They do no sales - so they get no retail discount.
They have people three levels below them - so they receive 5% of their production - but their immediate network is either senior and doing few sales or sclerotic). This is the only income they get - and it is 5% of three levels.
They are unequivocally blocked on the "production bonus" so they get nothing there and
They are not Chairman's Club or above because they recruited only three people - and if the recruited more they would be blocked for most of it anyway just because the very early guys have all been blocked out unless they kept growing their network.  
So all they get is 5% of three levels down - which is likely to be trivial - probably less than $5000 a year.
Note the 50% plus the 15% plus the 7% plus the 1% is the famous 73% payout ratio. It all gets paid - just not to the foundation recruiter. In fact it gets paid to people they recruited, people who worked hard to build networks and make more sales.
It is worth examining how you qualify for the senior levels in the sales structure.
To become a sales leader you need to sell 4000 volume points (roughly $4000 worth at retail) in a year. After that you become entitled to organizational volume - volume from your three-sales-leader deep downline. 
If a regular customer replaces 400 meals a year and consumes 600 volume points then you should be able to do this on about 7 regular customers. 
To stay a sales leader you need to requalify every February.
There are about 350,000 sales leaders globally and a little over half requalify. The average sales leader does many times the required volume. [The number of sales leaders being recruited is currently falling but the retention rate for sales leaders is rising. The reasons for this trend are discussed below.]
To make Presidents Team and be entitled to production bonus is fairly simple - but it looks awful hard to do. You need to get 200,0000 volume points per month for three consecutive months in your "organization" - that is three sales leaders deep. In other words three layers deep you need to be replacing somewhat over 100,000 meals per month - and that would require say 2000 people on a regular diet.
This could not be done by inventory loading because you need to do it for three consecutive months. The fact that anyone qualifies as a President's team member suggests the core Ackman thesis is wrong. However there are between 1-4 qualifications globally per month. Quite a few people have met this - and people are building new and sustained organisations fairly regularly.
There are many dans in the Presidents Team - and to reach the highest dan (and get the maximum production bonus) you need to be doing 1 million volume points per month in your organisation.
To become Chairmans' Club you need five separate Presidents' Team members below you (I am not sure what level of the Presidents' Team they need to be). This can't be done without bringing huge training and infrastructure to your Presidents' Team aspirants. It seems extraordinarily difficult to qualify as a Chairmans' Club member but most years 1-2 people make it. When I have met these people they are as organised and competent as the senior sales staff at say Oracle. There is a high degree of professionalism required to do this.
There is one level above that - so rare it is almost theoretical. That is "Founders Circle". To become Founders Circle you need ten Presidents' Team members of the highest dan in ten entirely separate downlines below you. To my knowledge only four people have ever achieved this. If there is a new ascension once a decade I would be surprised.
The remuneration system is - in my opinion - a work of genius. The senior staff have to build huge organisations below them and do huge amounts of mentoring to succeed. And then they have to continue to do it or their income tails off to zero fairly rapidly. If they do not keep working their downline eventually has people rise to their level and they are blocked from receiving income. Herbalife senior positions are a golden-treadmill - where people wind up working huge hours to maintain their network and to make sure they are not blocked.
The compensation plan and the ability to know - this is a perfect stock to research
To make this compensation plan work the company has and requires a very comprehensive (Oracle) computer system. Moreover distributors have access to their part of the system - so if you are a Presidents' Club member you can see everything in your downline. You can see how much they are ordering, their address, the repeat orders, who they have recruited. Everything.
This is a necessary part of running a Presidents' club organization. The senior distributor sees a sales leader whose sales are rapidly increasing they can find out why - and spread the good word. If a sales leader's sales are dropping off you can call in for some mentoring. This is all done by a typical Presidents' Club member.
The Presidents' Club member will also tell you accurately what is happening in their downline. They are not company insiders - they are independent contractors. And they will tell you how hard they work and how many people are in their downline and what gets people to sell and what does not because they are keen to recruit you and get you to do the same.
If you talk to six or seven independent senior distributors you can get a very accurate idea of what is going on in the company in real time.
This is a company where what would normally be "inside information" is legally and freely available for anyone who wants to talk with a bunch of distributors. It is the rare case of a company in which you genuinely can know the important details of sales and profits.
It rewards work. It is amazing to me that most of Wall Street has taken some interest in the Herbalife debate but very few people have done this sort of detailed work.
When I talk below (and I will talk below) about what is going on with sales and the change in the marketing plan - it is an area in which I can know. I may be "speculating" but it is very informed speculation. I have talked with enough distributors to know the basic trends. These distributors do not cover the whole company (I am not that well connected) but they cover a wide sample. For the moment all I am going to say is that this looks like a fantastic stock and about to get rapidly better.
Models of Herbalife distributors
Herbalife distributors vary according to the culture they are in. It could not be any other way – this is a distributed sales model where local entrepreneurs work out what works in their community.
The model Wall Street is most familiar with is the “cafe-style” distributorship in Queens. These are very poorly equipped generally – often poorly lit and decorated. They reflect what it is like living as minimum wage workers in greater New York (for an affluent Wall-Streeter they are grim).
The (relatively grim) Queens clubs however are far from the only model.
The China model that I saw at all three distributors I visited in China was one where you had a fitness assessment, weight loss goals and the product was sent to you at home for consumption. The only meetings were group outings limited to 40 people. The 40 person limit was driven by Party rules which Herbalife complies with.
The Arab model (which I gather is repeated in Abu Dhabi and a few other places) is a group-hug model. The club is held in someone's very cheap space but includes group discussion and group exercise. [There are clubs in Abu Dhabi – but I did not get to visit them when I passed through. It has become a hobby to visit clubs in strange locations.]
One of the strangest models I know exists on the coast of Thailand and Cambodia. I mention it only because Bill Ackman made a big thing in one of his presentations about how Herbalife had gone to Cambodia and hence was “targeting” the poorest people in the world. This has also become part of the SeekingAlpha hit pieces. It amazes me however that Pershing Square has strong views on Herbalife in Cambodia without going to look.
So let's look for him. These clubs on the coast of Thailand and Cambodia exist in the major sex-tourism destinations – places where men go and drink beer under the shade of some awning and are fawned on by younger women who want them to buy “lady-drinks” from which they get a commission. They will also go home with client if they pay a “bar-fine”.
Venues that are “beer bars” in the afternoon are sometimes Herbalife clubs in the morning, with older women running the club. The customers are overweight German and Australian expats [sexpats in the jargon]. You can find some of these clubs online complete with before-and-after photos of formerly fat Europeans sexpats. I won't do it for you – but just pick your sex-tourism hotspot and google it with the words “nutrition club”. I only raise this so bluntly because it is a clear and unequivocal place where Bill Ackman was wrong. There are real customers. And they are not the poorest people in the world. [Besides, when the community that Herbalife is in is a sex-tourism community why should you be surprised that some entrepreneurial local distributor has targeted sex tourists?]
There are Herbalife clubs attached to Yoga studios. Think middle-aged housewives wanting to lose some weight and get some flexibility. They buy a little shake as well. More generally there are large fitness clubs which sell Herbalife. A fairly good example is in Sydney – it is called 24FitClub. The model here is often that there is a free fitness meeting in a park (usually on a Sunday morning). The fitness events also sign people up as Herbalife customers – and when you pay for Herbalife you are paying for the fitness event and the commodity shake. This clearly answers the short-seller question as to why people pay more than market for a commodity. [It is that they are not buying a commodity.]
Some of these clubs – particularly in Malaysia – are very large indeed (a thousand members has been quoted to me in one instance). There are clubs that meet in the park that have hundreds of members – and they also meet for fitness dances in gymnasiums (rented for the occasion). This works very well in places where women (Muslim) have a social restriction on dancing and the distinction between dancing and fitness exercises is blurred. They become Muslim dating clubs. [There are videos of such clubs on YouTube if you are interested.]
In every one of these cases protein shakes are being sold with “community” and in every case real customers exist. These clubs are a direct answer to the Ackman question – asked many times – as to why would anyone buy overpriced protein shakes at full price (or even a 25 percent discount) when cheaper stuff is available online and in supermarkets? The answer: you get more when you buy it from a distributor.
Lead-sellers
As noted above, there is one point where Bill Ackman seems to have some legitimate points – the former presence of lead-sellers in Herbalife's distributor base. In almost every multi-level marketing plan there are people who will sell “tools” to help you identify customers. These tools are usually something like a list of leads for people who have responded positively to a work from home business opportunity or the like. The “lead sellers” invariably sell the same lead many times.
Herbalife offers a refund on their products. As noted, the refund is now far-in-excess of Amway safe-harbour requirements. It has been increased to a full refund including postage.
Alas lead-sellers do not offer a refund.
Some people have paid $20 per lead. The money doesn't go to Herbalife – it goes to the lead-seller. There are plenty of examples of people who have been ripped off by lead-sellers at all MLMs. Indeed given the defences in the Amway safe-harbour (which is a 90 percent refund) the main way you can lose substantial money in a “goods” MLM is to lead-sellers. [Note that BurnLounge – which has been found to be a pyramid – sold music burning services – and it is very hard to argue that these are not consumed when delivered and refunds were not offered.]
Fairly early on in the Herbalife saga (early 2013) the company banned any lead-sellers from the organisation. [You were fired as a distributor if you were found to be selling leads.] I have not tested this hypothesis by finding someone who sells leads and seeing if they get fired – but Shawn Dahl and other lead-sellers left Herbalife. The company announced at the time that it would have a “low-single-digit negative effect on sales”. Truly if you look through the quarterly sales you can't see it. This was the first (of many) changes in the distribution rules that have had a negative – albeit temporary – effect on sales growth.
I have visited many Herbalife distributors – and I cannot find “victims”. One Hispanic President's Club member I spoke to said he knew no Hispanic “victims”. His customers ran communities – rather than being solo-operators who thought they could just sell stuff from home.
Field sales (and Mexico)
Go back to the 1970s when the Amway decision was made. Payments over the phone were difficult – not everyone had a credit card. Deliveries of small parcels to millions of individual customers were impossible. These were the days before Amazon and ubiquitous parcel delivery.
In those days – and it is the environment that permeates the Amway decision – the distributors took very large deliveries (half a garage full) and they in turn made deliveries to their customers and even small distributors. Most end sales were made “in the field”.
This of course left the possibility that the distributor would be left with a huge amount of inventory and could really only make money by persuading other people to similarly take a huge amount of inventory. It was in to this environment that the Amway safe-harbour rules were designed. Provided the company could convince that there were real customers (the 70 percent external rule) and that you could not get stuck with inventory (a 90 percent refund rule) then you were safe against a pyramid accusation.
The 1970s conditions no longer exist in America. UPS and credit cards are ubiquitous and it is entirely possible to make deliveries directly to end customers (as they do in China) and also to accept small payments from end customers.
Until very recently there were not widely available payment mechanisms in many developing countries. [Smart-phones have to some extent changed that.] To this day accurate and timely delivery of small parcels is not available.
Many of Herbalife's distributors still live in countries with difficult delivery systems – and a few years ago Herbalife had never made a direct sale to more than a million of its distributors. Instead these distributors simply purchased from other distributors. Sales from other distributors are called “field sales”.
A field sale is a legitimate way of distributing product in countries with poor distribution networks – and indeed they were once common in the USA.
However they come with several difficulties for Herbalife. I will illustrate by example.
One difficulty is that field sales make it relatively easy to subvert the distributor networks... Cristine Richard in her article about “field sales” quotes a problem from several years ago in Mexico.
What was happening is, in markets or in states where we did not have distribution points, very entrepreneurial distributors were driving a pickup truck to a distribution center, picking up product and then selling to people that were not in their organization. (Bank of America Securities Consumer Conference, March 12, 2009)
This means real customer were buying real product but they were doing it in a way that circumvents the standard distributor network. Herbalife goes to extraordinary extents to protect distributor businesses (for example it will not allow online sales). The purpose of this (as described above) is to protect a distributor's “second sale”. Herbalife will ban distributors for behaving like this – and this disrupts sales and selling. If there were no field sales this would not happen.
More importantly field sales can be used to game the promotion rules at Herbalife. To become a Chairman's Club member you need to get five distributors below you of a certain level of President's Club. This matters because when you do so you block the Chairman's Club member above you for part of the royalty – and so getting a fifth President's Club member below you matters.
To game sales just shift-them around a little – and do some compensation of the person you shifted from. It is tricky but can be done in a field-sales environment whereas it cannot be done in a direct delivery environment.
There was an incident in Argentina a few years ago where this happened. There was an ascension to the Chairman's Club (thus shifting around considerable royalty entitlement) and this ascension was disputed and then reversed. To say this caused ructions in the distributor network is understating it. People did not trust each other any more. [I gather from discussions that this was not the only such incident – but I cannot vouch for others...]
There is a final problem with field sales – and this is particularly evident in Mexico. If all the sales are field sales Herbalife has far less control of and ownership over its network than is desirable. In Mexico there are three senior distributors who have built a network of distributors that cross the country. This network of distributors can do same-day deliveries to most of Mexico – which is darn useful – but alas comes at a cost to the company which is that they have ceded most the power to the distributors. Herbalife does not have a personal point of contact with their customers.
Importantly the widespread availability of payment networks in the developing world (via smart-phones) has allowed Herbalife to fix this – getting much more detailed information on its network and gaining control over its distribution. This is a substantial strengthening of Herbalife's business – but it comes at some short term cost. The short term costs (described in more detail below) are evident in the accounts for the last few quarters.
Other rule changes
Whereas the rule change banning lead-sellers did not have an appreciable effect on sales, other rule changes have. They are – in my well-supported view – the reason why sales have been weak at the moment.
The rule-changes are superficially a response to Ackman. Specifically the company has insisted that multiple orders are placed (over time) to qualify as a sales leader (the key distribution level).
In the past you could qualify for a sales leader with a single large order of 4000 volume points (about $4000) or with several orders (totalling 5000 volume points) placed over a year. The large order was called a “success builder order” and was a key exhibit in the claim that the company was a pyramid scheme. After all – encouraging people to buy large amounts that they can't sell is a key feature of pyramid schemes and is the feature that the Amway rules were designed to ameliorate.
Recently the company changed this so that the only way that you could qualify as a sales leader was with multiple orders spread over some time. If you can't sell the first order of say $1000 then it is unlikely you will be stupid enough to make another $1000 order.
No pyramid scheme would make this change – but Herbalife has rolled it out over the world. They started in Russia and some parts of Eastern Europe and the Middle East (test markets) but have now rolled this out globally. [The Club in Israel described at the beginning of this post operated under the new rules.]
This rule change is a very effective defence to the Ackman claims – a pyramid scheme simply would not do this. And when talking the company presents this as one of the reasons why the scheme needs to be rolled out.
However I think this is only part of the story.
The second part of the story is that involves cleaning up field sales. You cannot enforce a multiple-order rule if the orders are field sales and the upline distributors just fulfil the order. They could – of course – take a single order and enter it in the computer system as multiple orders.
So the company made a very important change – one that will change the nature of the company for decades. It now insists that orders to qualify as a sales leader (the key distributor level) are placed with the company directly – and not via field sales.
In the United States this is almost no change. In Mexico it is huge. For the first time Herbalife will have a direct relationship with all of their key distributors.
Making it work however is hard. The company needs to get their own delivery network up to the standard of the warehouse network owned by the senior Mexican distributors. They have had to rapidly get something like 1200 company controlled and company stocked distribution points in Mexico. They did this effectively and quickly. [This is a company that really can execute – it is – on the ground – one of the best management teams I have ever seen.]
This dramatically strengthens their business.
However it has very notable negative short-term effects on sales. For a start slower first orders just – well – slowed down sales. There is no surprise there. This effect was visible in every jurisdiction and in jurisdictions where it was trialled some time ago [notably Eastern Europe] sales have bounced back.
How do I know they have bounced back?
Well some distributors in those areas have shared their data with me. This is one of those things about researching this stock. Because the distributors are independent contractors with good data you can get very accurate data from them. You can know.
Importantly the move away from field sales – particularly in Mexico - have resulted in the upline distributors destocking their warehouses and the company stocking their own. This will result in temporarily lower sales (as the distributors destock) and a permanent increase in inventory (as the company warehouses get filled). Cash flow effects are negative and it was these cash flow effects that were most visible during the fourth quarter of 2014. After those results were released the shorts (including Bill Ackman) were crowing about falling cash flow. [See this SeekingAlpha article for an example.]
The real sales effect of the rule change
Herbalife's senior distributors don't just sit around and gather their checks. If they did they would shortly get blocked in the distribution chain. They are active sales people building distribution chains. In Mexico that meant many things including building warehouses.
However the main thing that senior distributors do is they mentor downline distributors. If you spend any time with a senior distributor you will see this in action.
When they get a new sales leader there is a lot of training involved. It is – frankly – a waste of their time if the new sales leader drops out quickly. If the new sales leader seeks a refund of product it is doubly a waste of their time as they do not get paid at all.
The key determinant of upline income is how many of their downline builds communities around them – how many build sustainable (albeit often small) businesses.
When you talk to distributors you find that their key determinant of success is a retention rate. Most people who join Herbalife drop out. Most sales leaders fail to build successful businesses. [This is true for all diet products – I do not think Herbalife is unusual here.]
But I have seen senior distributors for whom over 90 percent of sales are to repeat customers. There are enormous numbers of new customers – but the total sales to new customers do not add up to much. It is the retained customers that account for almost everything.
The distributors with repeating business are valuable and the core of their income. New customers are only really worth something to the extent they produce repeat business.
Now here is the rub. In the markets Herbalife tested with the requirement for slow qualification as a sales leader the retention rate was higher. Quite a bit higher. And the upline distributors spent much more of their (limited) time training people who were successfully building repeat businesses. And this had a sort of snowball effect on sales. The first effect of the rule change was that sales fell.
After that they grew. And then they started to grow at an accelerating rate. Distributors qualified under the new rule are (a) much more likely to produce repeated sales and (b) much more likely to recruit people who in turn produce repeat sales. The distributors are profoundly happy with the rule change – and they are seeing their income rise. The income-to-effort ratio is also changing favourably.
How do I know? Well distributors have the data. I said that above.
This is simply wonderful as a shareholder or potential shareholder. There is currently some weakness in Herbalife sales. Herbalife has guided for increasing sales in the second half of this year. If the trends here follow the test markets those increases are in-the-bag. Better – if the trends follow the test markets then not only will sales and earnings accelerate, they will accelerate at an accelerating rate.
Herbalife once exceeded earnings expectations for 21 straight quarters. Although the Ackman/Einhorn hiccup was in the middle of this – generally this was a very good time for Herbalife shareholders.
Here is the trick. If the test markets are a guide (and I believe they are) then that record will be repeated, but this time the earnings will accelerate. Big numbers are possible. I don't think anyone other than the wildest bulls expect accelerating growth from here – but that is a distinct possibility.
Summary
At something close to 20,000 words that is long enough. I will be getting off the plane shortly anyway. So here is a good place to finish.
What we have however is a short-case built on arguments that do not fit the facts-on-the-ground.
On the ground this is an ethical company that does good things and builds huge and sustaining communities around its products.
Moreover it is doing rational things that are short-term earnings negative but will strengthen the business and set the company up for not only growing earnings but accelerating underlying sales (and hence earnings) over the next few years.
Management is focussed on shareholders. Their execution is excellent (see the build out in Mexico).
And there is a 30 plus percent short interest in the stock.
And the starting price-earnings ratio is modest – considerably under the market average.
There isn't a better stock in my portfolio. It will eventually go well over $200 [even without short-covering]. The stock is indecently cheap now. And the company is of the highest quality.



John

PS. There has been two amendments to this post. 

In the original I suggested that the biography that Ms. Richard wrote of Bill Ackman and his MBIA short was a "paid" biography. I have been reliably informed by someone with links to the publisher that it was not. The suggestion has been removed.

The second amendment is that the person who asserted to me that Cristine Richard planted the David Einhorn question is less than sure about this and I have mostly removed the assertion.

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Finally a few people have questioned why I called David Einhorn's questions "poisonous". Well at a trivial level an instant and substantial drop in the stock price suggested many people agreed.

But more generally (a) the company answered them very badly and (b) I am not sure there was any way they could answer them well. In that sense they were - at least to public perceptions of the company "poisonous". Once asked public perception was going to change.

The questions were not unfair though. "When did you stop beating your wife?" is the classic unfair question because it pre-assumes the nasty facts. David did not pre-assume the nasty fact in that way. But I think they did pre-assume an interpretation of the law - an interpretation since made irrelevant by BurnLounge.

J

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One more correction - Anthony Powell, not Peterson was the distributor who left over lead-selling - along with Shawn Dahl.

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.