Though the activist investor news front this week is honed on David Einhorn's lawsuit against Apple, Bill Ackman's Pershing Square is still making waves about alleged pyramid scheme Herbalife (NYSE:HLF). The story cooled in recent days following the televised blowout argument between Ackman and Icahn, but it would be foolish to think that Ackman's attack is taking a break. Citing Herbalife management's oft-mentioned dedication to transparency, Pershing Square has released a few questions -- 40 pages' worth -- which it wants answered regarding Herbalife's business model and its products. While all are valid questions, here are three crucial questions from Pershing to Herbalife.
The Big Kahuna
Of course, the core question here is the most widely asked: Is Herbalife a pyramid scheme? However, just like a heated political debate, the grand question can be misconstrued and picked apart to make it virtually impossible to deliver a "yes" or "no" answer. Pershing Square knows this, and its questioning has gotten more specific while still trying to prove the overall thesis.
On its first page of questions, Pershing begins:
Based on Herbalife's reading of the 2004 FTC Staff Advisory Opinion, the Company appears to conclude that "the primary motivation for purchasing should be resale and / or consumption." This conclusion suggests that Herbalife believes that internal consumption is otherwise indistinguishable from independent third-party sales in the FTC's determination of a pyramid scheme. As recently as November 2012, however, the FTC published the following on its website: "One sign of a pyramid scheme is if distributors sell more product to other distributors than to the public – or if they make more money from recruiting than they do from selling.
In light of the FTC's November 2012 statement, why does the Company continue to look to the FTC's 2004 Opinion for guidance as to whether or not internal consumption is a red flag for a pyramid scheme?
This question gets to the heart of the matter immediately. Herbalife has been very quick to say it has always operated within the rules and guidelines of the FTC. The company provides data for product it sells to distributors, but claims it cannot accurately track the final destination of the goods -- whether it gets consumed by distributors or resold to end users. The two are not the same, and it should not be treated as such, as noted in the FTC's November 2012 memo.
If it's true that Herbalife cannot currently provide accurate sales data for its products once they leave the warehouses, then the company needs to start. In a traditional franchise model (where the franchisee can be considered an independent business owner/distributor), the parent company typically knows good and well how much of its product is actually being sold -- because a good part of its profits are royalties on sales. If Herbalife is to prove itself a legitimate business, maybe it should look more like businesses that don't toe the legal lines.
An unreasonable request? Similar business Tupperware provides retail sales figures regularly, as seen in a Jim Cramer interview with the company CEO earlier this year.
Injunction, your Honor
In 1986, the state of California issued an injunction on Herbalife and its employees. Among the requisites to continue operating the state, the injunction stated that:
...defendants shall be in compliance with this Section 5, as long as a verification or documentation system they implement allows them, at any given point in time, to verify or document to plaintiffs that any and all participants who receive commissions, bonuses, overrides and/or advancement from defendants in defendants' marketing program, after entry of this judgment, are based on retail sales made by or through such participant(s) or others introduced directly or indirectly under participant(s).
This basically means that the company needs to be able to prove it is selling products to non-members at the end of the cycle in order for the distributor commissions to be lawful, according to the injunction. Yet, in May of last year, Herbalife filed an 8-K that stated the following, "We don't track [sales to non-distributors] and do not believe it is relevant to the business or investors."
How can the company be in compliance in the state of California with the 1986 injunction still in effect?
Management will likely say the state has taken no further action against Herbalife (headquartered in Los Angeles) and, thus, they are in full compliance with 1986 injunction. Of course, California may have more important fish to fry than Herbalife at the moment. One of the few avenues out of bankruptcy for this company would be to go back on its dedication to losing track of product once it leaves the Herbalife warehouse.
Sales broadly from abroad
Herbalife states that 92% of its sales are generated from mature markets, defeating the notion that its growth is fueled by a pop-and-drop strategy in emerging markets that takes advantage of low-income citizens in those areas.
Why is this analysis based on Volume Points instead of Net Sales?
We note that based on pricing sheets obtained from the Internet, the ratio of Retail Sales($USD) to Volume Points for Formula 1 in Malaysia was ~2.1x in 2011, but only ~0.6x in Japan.
Why does the ratio of Net Sales to Volume Points vary significantly in certain mature markets versus certain emerging markets? In light of the disparate ratios of Net Sales to Volume Points in different markets, isn't it misleading to attempt to demonstrate consistent growth using Volume Points rather than net sales?
Pyramid scheme allegations aside, this is a matter of accounting trickery. The company's dramatic growth over the last few decades hinges on the idea that the company picks up long-term distributors and customers, and not solely by opening up shop in every country on the globe to sell product internally. Herbalife needs a clear-cut answer as to why it uses volume instead of sales figures to show growth in different markets. In any other retail circumstance, analysts look for the sales growth over all else.
You have a lot of explaining to do...
I am not sure that any of the questions will receive the answers they warrant from Herbalife management, as the team has yet to address Ackman's concerns in a material manner since his initial attack in December. But hopefully, as these questions become more and more common among us, Herbalife will be forced to live up to its claim of absolute transparency to the public.
As usual, I strongly recommend investors stay far, far away from this stock.