Tuesday, July 30, 2013

Herbalife is addressing Bill Ackman's concerns...

Bill Ackman spent eight pages of his presentation (100 to 107 inclusive) covering the issue of shipping surcharges. His argument was that the retail margins were misstated because customers had to pass along a 7 percent shipping charge.

The issue Bill Ackman raised concerned me.

It is pleasing to see that the company is addressing these head on. From page 28 of today's 10Q:

(1)During the second quarter of 2013, we simplified our pricing structure for the North America region by increasing suggested retail prices and reducing total shipping and handling revenues by a similar amount, eliminating a “packaging and handling” line item from our invoices to distributors. We do not expect these changes to materially impact our consolidated net sales and profitability. We anticipate extending these changes to additional markets in future periods.

As a long investor it is encouraging to see perceived deficiencies being appropriately addressed.


Sunday, July 28, 2013

Bronte is hiring - a follow up...

APPLICATIONS ARE NOW CLOSED. We received 270 plus - and we are finalizing a short list...

As many know - Bronte Capital - the asset manager - has advertised for their first employee.

I have gone through my email fairly carefully and I should have replied to every single application although more than 200 in the negative.

I found five applications in the "junk mail folder" and I fear I may have missed a few others.

If I have not replied to you please resend to brontecapital@gmail.com and make sure you get a reply. If you are interested enough to consider working for us and devoting a good part of your life to Bronte then we owe you the courtesy of a reply.


We are currently about half way through a "preliminary round" interview where I ask some questions testing

(a) basic science and a scientific understanding of the world,
(b) thoughts about how you may build our computer systems [targeted at our quite unusual needs], and
(c) business analysis [mostly for looking at longs].

We have found nobody who answers all three sets of questions well - but a few who answer two of the three well.* [Some of these people are very high quality - just not entirely on our needs...]

This means that eventually we will need more than one employee though we are at the moment very focussed on the computing problems and we would prefer doing those things really well. [We are not much into compromise...]

All of the people who do "two out of three" well are expensive: they have good jobs, are aged over 30 and I would need to promise them a lot to make them move. [And I am reluctant to promise a lot for a compromise employee...]

I will consider someone who does the computing part well but is cheaper (which probably means younger). I would probably hire a young, entrepreneurial computer geek who wants to be taught the business analysis stuff - especially if they were Australian based already... If I get someone like that I can spend more on the next employee.

Above all else I am interested in intellectual firepower (I want to hire people smarter than me, especially in the computer task) and the ability to actually implement this stuff.

Still I have another 20 or so preliminary interviews to go. Who knows what I will find...


*I have high standards. One senior Silicon Valley executive I tested on the questions suggested that he knew several people under 30 who meet my criterion - but they are mostly going to wind up worth 100 million dollars - and that a surprising number worked at Facebook. He thought I was being unrealistic.


Friday, July 26, 2013

Good and bad MLMs: Pampered Chef, Herbalife and Nuskin

Aalaya Walker (Florida - Aged 18) was shot (but only slightly injured) when she pre-heated her friend's oven. She was wanting to make waffles.

Her friend, who obviously did not cook much, kept the ammunition in the oven because it was safe there.

There are lots of people in America who don't cook or can't cook and have never learned how. Real estate agents tell stories of people with beautiful appliances who keep all the manuals in the oven because they too never cook.

Many of these people eat a lot of fast-food, are overweight or modestly unhealthy and they miss the family or social aspects of sitting down with a nicely cooked dinner and a couple of bottles of wine and for that matter - perhaps getting plastered.

Enter The Pampered Chef.

Here is The Pampered Chef shtick at its best. The Pampered Chef "consultant" finds a man or woman (usually a woman) who does not cook much if at all - and would never hold a dinner party. She gives them a shopping list...

Two loaves of good bread
A couple of onions
4 small carrots
Some rosemary
Some olive oil
Some chicken thigh or breast fillets
Some cayenne pepper
A bulb of garlic
Any other herbs you like (parsley, sage, rosemary or thyme, whatever you like)
Couple of tins of lentils, Puy lentils if you can find them
Couple of ripe tomatoes
Bag of frozen spinach or fresh spinach
Some bacon
Some asparagus
Some yogurt 
8 friends
4 bottles of wine

It is of course the 8 friends and four bottles of wine that makes this really work. This lot makes one of those wonderful French provincial dishes (peasant food) that all my hedge fund manager friends have presented to them as Haute Cuisine.

The whole thing can be cooked in twenty minutes (see Jamie Oliver's 15 minute version below).

But the "consultant" takes thirty five minutes to cook, giving friendly cooking tips along the way - and sloshing down a little wine. Also they explain the cookbook has lots of other wonderful and easy recipes.

Then they sit down and eat it. To someone who holidays in the South of France and eats in French Bistros this is just a darn nice meal. But to someone whose diet consists of fast food its a revelation - exotic beyond belief. Just so tasty.

And as the wine gets consumed, cook, books, fry-pans and other things are sold.

If all is going well desert gets cooked, mostly at the table. Some eggs are separated and whipped up with sugar. The meringue is dumped in the oven (after the ammo is taken out). Some cream is whipped, strawberries crushed to make a coulis, and Eton Mess is served in nice glasses. All that cooking equipment is sold too.

The consultant becomes friends with two or three of the other guests and organizes another two dinner parties...

This is a real business, it really adds value and it is fun. Hell I would even go but I suspect I have enough frying pans... it is far less exploitative (and far less unreasonable) than a Tupperware Party.


It is hard to argue that the above scenario is exploitative even if the frying pans are sold at three times fair value. Indeed Doris Christopher who founded the Pampered Chef originally just purchased the kit at The Merchandise Mart in Chicago and marked it up three times.

Walmart cannot sell frying pans this way because they can't get into peoples homes and explain how they are used. In this case what is being sold is "community" - and it can't really be sold any way other than MLM. MLM is a pathway into the community that is not available to a conventional corporate.

The dumbest part of Bill Ackman's presentation (and for a smart man he can be so stupid) is where he complains that Herbalife products are unreasonably priced - and describes the product as a commodity.

Doris Christopher purchased commodity frying pans at Merchandise Mart. What she sold was something else entirely.


This is all fairly instructive on what makes an MLM a societally value accretive business. Its a good business if it works out how to create value out of community. In that case the MLM really is doing something that conventional retail can't do - and if they capture profits - even considerable profits - doing so - that is just normal business.

And I am going to make a strange argument - MLMs - at least to the extent that they create value out of community - should trade at a premium to traditional retail rather than a discount. Conventional retail is vulnerable to the internet - MLMs doing this sort of business are far less vulnerable... 


But MLMs are not all good - and the critics do have something to say. MLMs do leave a trail of disappointed distributors - and they are not hard to find.

The Pampered Chef "consultant" who runs the above party may or may not be disappointed if the parties only make her a few thousand dollars "supplemental" income a year. After all she probably likes to cook, likes parties, likes meeting new friends and has a good time doing it. The fact that she does not get rich - or even earn minimum wage per hour for this - is not really material. It may be lightly profitable but good fun. My guess is that the profit share belongs disproportionately to Berkshire Hathaway - and that is the way Uncle Warren likes it. But it is also the way the world is.

There is a problem however if the consultant has to buy tens of thousands of dollars worth of frying pans to sign up as "consultant". She may never recover her investment. I have not talked to many "consultants". There may be a few out of pocket - but I doubt it is tens of thousands of dollars.

Still even Warren Buffett has been in the game of misleading consultants. The forward to The Pampered Chef Cookbook is written by WEB. To quote:
When you read the profiles of The Pampered Chef's Kitchen Consultants in Chapter 8, you may wonder what you are doing in your nine-to-five cubicle while these folks are happily cooking their way to fame and fortune.
Warren: despite your (well deserved) reputation for integrity this is BS and you know it's BS. You are vanishingly unlikely to find "fame and fortune" as a Pampered Chef Kitchen Consultant.


But misleading consultants is only one of the things wrong with MLM business models. The main other thing wrong is decentralized law avoidance.

Let me give you an example. Nuskin - another listed MLM - sells a variety of vitamin pills through a multi-level structure. Their main product is some exotically packaged pills called "lifepak nano" (punctuation as on the pack). Here, photographed on my desk in Sydney, are some pills...

They are just vitamin pills - there is little that is "special" about them - well except that as the pack says - they have "enhanced molecular delivery" whatever that is...

Here is a list of ingredients...

On the Nuskin website they make some strong claims...

  • Nourishes and protects cells, tissues, and organs in the body with the specific purpose to guard against the ravages of aging each day of your lifespan*
  • Superior bioavailability with CR-6 LipoNutrients™ enhances uptake from the gut into the bloodstream and body for maximum anti-aging benefits*
  • Advanced anti-aging formula helps protect the body with key nutrients such as NanoCoQ10™ and nano carotenoids*
  • Helps maintain normal inflammatory responses in the body*
  • Feeds and helps protect the brain with DHA and EPA (two CR-6 LipoNutrient™ softgels contain the same amount of EPA and DHA as two MarineOmega softgels)*
  • Offers superior DNA protection against damaging free radical attacks by providing the body with important antioxidants and phytonutrients such as alpha-lipoic acid and catechins*
  • Protects cell health with an antioxidant defense network*
  • Helps protect cardiovascular health with a comprehensive blend of omega-3 fatty acids and other nutrients
  • Provides comprehensive bone nutrition support*
  • Promotes healthy immune function*
  • Supports normal blood sugar metabolism*
  • Corrects nutritional deficiencies*

 You will note that every one of these claims is marked with an asterisk. The asterix is as follows:
*These statements have not been evaluated by the Food and Drug Administration. this product is not intended to diagnose, treat, cure, or prevent any disease. 
The company is careful on its website not to produce any literature that violates Food and Drug Administration law. You can't sell pills in America in breach of FDA rules without risking unpleasant legal complications.

But this is an MLM - and you can bet the distributors are not so careful. These little pills are sold as miracle cures - and Nuskin distributors are the snake oil salesmen of old - blithely violating FDA law and desperately difficult to prosecute because the sales force are not employees of the company.

Decentralised law avoidance is a feature of many MLMs. To my knowledge it is not a feature of The Pampered Chef. The Herbalife sales people I have visited have stuck extremely closely to the company provided (and legally vetted) sales scripts. In the cases I saw that sort of decentralised FDA avoidance was not an issue.

But the Herbalife clubs did not always have cash registers and they did not always have the little A+ or similar to indicate that they had complied with health laws (even though they sold food). In other words there was some low-level decentralised law avoidance.

A ranking of MLMs

I am happy to concede that The Pampered Chef is the gold-standard for MLMs. It makes its money because it packages community - indeed community rather than frying pans is the product.

At the other end Nuskin makes a good proportion of its money because it decentralises FDA non-compliance. [And I am not getting anywhere near the China business of Nuskin which other people have commented on widely...]

Where is Herbalife in this? I haven't seen much decentralised legal non-compliance with Herbalife. Maybe a little around the edges - but it is not the reason the business works. The reason the business works is that diets require community to sell. In that sense Herbalife is far closer to the gold-standard Pampered Chef than say to Nuskin.

In my neighbourhood you can buy your diet protein shakes from the discount shop, the (far more expensive) GNC shop or from the hot fitness or yoga instructor. And the hot fitness or yoga instructor is a better product. (S)he will ring you up and ask how your diet is going... That adds incentive to diet and thus adds value. Its a long way into The Pampered Chef gold-standard territory...

I have more than a few problems with Herbalife - not the least is the (huge) amount paid to the CEO. But Herbalife is fast growing and deeply embedded in communities selling products that need communities to sell.

Relative to The Pampered Chef it is easy enough to find disappointed Herbalife distributors - especially in the Hispanic Community. However there are few around here - and the Herbalife business is growing again in Sydney (despite Bill Ackman's claims of pop-and-drop collapses).

Speaking as a shareholder here - Herbalife has been plenty happy to pay dividends and buy back stock. Over the years it has repurchased (literally) billions of dollars in stock - and the share count has reduced considerably. The shareholder-friendliness is - CEO pay notwithstanding - at the better end of America. And Herbalife is growing.

I am not a lover of the MLM business model and I was (very) surprised when Berkshire purchased The Pampered Chef. However why Bill Ackman chose Herbalife to fight to the death - that escapes me.


Thursday, July 25, 2013

An incomparable business opportunity allowing men and women to build a home based business of their own...

Herbalife is regularly criticized for selling the "business opportunity" rather than nutrition products. Indeed Bill Ackman (Herbalife's loudest critic) has used the following statements as evidence that what Herbalife sells is a "business opportunity" [which is a pyramid scheme] rather than products for end consumption. Herbalife is - in these statements:
"An incomparable business opportunity allowing men and women to build a home based business of their own", 
"An approach that has a lot to teach anyone who is reaching for the American dream", 
"Truly loved by its customers because it has found a need and filled it exceptionally",
"When you read profiles of the consultants [sales people] you may wonder what you are doing in your nine-to-five cubicles whilst [the consultants] are on their way to fame and fortune".
These statements of course are ample evidence that Herbalife is not really selling product but selling a fraudulent "business opportunity" and is in fact a pyramid.

Except that I am playing a game of misdirection here. These statements are not about Herbalife and they have not been criticized by Bill Ackman.

They are the statements about another multi-layer-marketing scheme - "The Pampered Chef" and they are made by none other than Warren Buffett. Warren Buffett (through Berkshire Hathaway) owns The Pampered Chef and its 60 thousand plus "consultants".

In a future post I plan to talk about why The Pampered Chef is a business worthy of being owned by Berkshire - why it meets Warren Buffett's (very high) business quality hurdle - and how Herbalife has some, but not all of the properties of The Pampered Chef.

But for the moment I want to note a few things.

(a). Herbalife and The Pampered Chef were both founded in 1980. Bill Ackman criticized Herbalife for being a recent company founded in 1980 - see this screen shot from Bill Ackman's presentation.

(b). Herbalife is much bigger than The Pampered Chef and more deeply embedded over the world, and

(c). Herbalife is growing at a high rate both relative to its past and relative to The Pampered Chef. Indeed if you look at Google Trends data Pampered Chef is in a slight decline but Herbalife has more interest than at any time in its history. In the following chart (courtesy Google) Blue is Herbalife searches, Red is "Pampered Chef".

(d). Herbalife is taking off in some large important markets. This for example is the UK:

This is the (potentially vast) market of India:

And even in markets that were once declining is re-emerging strong. (This is Australia...)

Pyramid schemes are expected to collapse under their own weight - and so if Bill Ackman is right it shouldn't matter what I say. But if Google Trends data is right then Herbalife is likely to beat estimates maybe offset a little bit by the strong US Dollar.


Multi-level-marketing schemes and their distributors: notes on disappointed distributors at Herbalife and elsewhere...

When I was in my twenties I lived in outer North-Western Sydney for a year - mostly around Kurrajong. Multi-level marketing schemes were part of the environment - but two stood out: Amway and Avon.

Amway sold stupid and overpriced products which were direct substitutes for things that you could buy in a supermarket. I remember overpriced washing powder - and that is still there. (Check out this link where you can buy washing powder at 27 Australian Dollars per kilogram!) The Amway sales people (at least the ones I met) were a collection of drug dealers and no-hopers. I think at least one used Amway for (im)plausibly arguing that they money they had in their pockets was clean (when it came from dealing drugs). You could probably buy weed from many of the local Amway dealers.

I only met one Avon lady, a cheerful lesbian in her late 20s. She was (relative to the neighbourhood) quite prosperous and had an acre of land and horses. I briefly lived in a room attached to her stables. She was also (on her say-so but I have no reason to disbelieve her) the most successful Avon Lady in Australia.

Her shtick was simple: Western Sydney is a land of long commutes. Wives were stuck at home 11 hours a day (8 work, 3 commute) with the kids, lonely and getting depressed. The cheerful Avon lady would drop by and the women would play like 14 year old girls putting make-up on each other but without the cattiness... and the Avon lady would with all the (considerable and genuine) enthusiasm a lesbian could muster tell the housewife she was beautiful. And it was - like all good sales techniques - entirely plausible.

And she sold a lot of product. She sold (current dollars) well over quarter of a million dollars worth of product per year.

Now lets take Bill Ackman's rhetorical question about Herbalife and apply it to my Avon lady. Why would any customer buy protein shakes or cosmetics from a Herbalife or Avon sales person when similar products are available online much cheaper?

With the Avon lady the answer is obvious - which is that she was selling the service of making the customer feel good about themselves through lipstick, eye-liner and finger nail polish... she was not selling mere cosmetics. Multi-level-marketing provides a for-profit community support group and its name was Avon...

With Herbalife there is also clearly some of that. If I start a diet I am (statistically) not likely to stick to it. If I start a diet and exercise with a personal trainer (in this case preferably an attractive and cheerful individual who makes me feel good about myself) then I am probably more likely to stick to it (though still statistically likely to lapse).

Now the average Herbalife sales person is probably less inducement than the hot personal fitness instructor (except where the Herbalife sales person is the hot personal fitness instructor) but the effect is real. I described the Herbalife club in Queens as like Alcoholics Anonymous for fat Hispanic men: "my name is Jose and I am fat". And like AA Herbalife adds value through community support.

Indeed I suspect community support is actually more effective in weight loss than any individual supplement. Its the thing that keeps the dieter on the straight and narrow...

Failed and successful Herbalife distributors

McDonalds has a reasonable business. Being a McDonalds franchisee is also not a bad business - and the franchises trade hands for real (and sometimes considerable) money. McDonalds would however never franchise four restaurants (if you want to call them that) within one city block. If they did they would all be unprofitable.

McDonalds have a vested interest in their franchisees being profitable - profitable enough to keep the store clean, comply with labour and food safety laws and have toilets that don't stink. If the toilets stink and the food poisons customers McDonalds would fail.

Because McDonalds have a vested interest in the profitability of franchisees a franchisee of ordinary skill can make a living with a franchise - probably even a good living. That is why the franchises change hands for real money.

Multi-level marketers are different. MLMs simply do not have any control over the number of distributors. I might think that an area is saturated with distributors and that any more is foolish - but that is not going to stop you from recruiting - especially when you are paid as a percentage of distributor sales rather than distributor profits. MLMs will recruit until the profits of distributors go negative - sharply negative perhaps. If you find a profitable area as a Herbalife distributor (that is an area with lots of customers and limited competition) it will not remain profitable. Come back in five years - and there will be nine distributors none of which are making any money.

The MLM structure almost guarantees that most distributors have terrible businesses.

But it is worse than that. Your upstream distributor gets paid for recruiting you. And they get paid as a percentage of your sales - not as a percentage of your profit. They have an incentive to recruit you even if they know your business will be loss making. And they have an incentive to deceive you as to your prospects as a downstream distributor.

And if one of them (ethically) decides not to deceive you other upstream distributors will not be so honest. And so the network of an MLM - any MLM - is - simply by incentives - driven to the point where most distributors make losses and are recruited on false promises.

MLMs - all MLMs - are businesses that create and shatter the dreams of their distributors.

Herbalife does this too. There are many failed distributors - indeed the majority of people who try to make a living being Herbalife distributors fail. That is a feature of MLMs. Everyone who looks at MLMs closely brushes up against the failed dreams, the lies, the overly-slick and deeply unethical upstream distributors. This is true of Herbalife - and the rest of them - Amway, Avon, Tupperware, Nuskin, Pampered Chef and all the rest. [I am not accusing the MLMs of being disingenuous - just many of the distributors...]

High distributor failure rates does not make MLMs illegal. Indeed finding lots of failed distributors does not prove anything. It is to be expected - and there is no law that requires that everyone who opens a business - or even a majority of those that open a business make a profit. It does require however that a profit is possible because otherwise it would be misleading for the corporate to imply that the profit is possible.

And in most MLMs a profit is possible. Just ask the Avon lady above - who made enough money to keep land and horses in outer Sydney. But the Avon lady had a shtick. It was a good shtick and hard to duplicate. It meant she succeeded where others failed. And it was clearly an exception.

I have in looking at Herbalife found several profitable distributors. Indeed most the distributors around where I live are profitable albeit in a very small way. If you go down to Bronte Beach at ten o'clock on a Tuesday morning you will find fitness instructors keeping the local housewives in shape. The guys are bronzed and good looking. The women are the attractive thirty-something second wives of men rich enough to afford a house in Bronte. They are desperately conscious of their weight and appearance as they fear being traded in on a still younger model. And the fitness instructors not only sell fitness instruction and social reassurance [as in this bronzed guy tells them that they are attractive] but they sell weight loss products as well. Being a Herbalife distributor provides incremental revenue and little incremental cost. Its a good addition rather than being a good gig. And as noted above, a hot fitness instructor provides worthwhile assistance in weight control.

Distributor/customer failure rate

Losing weight if you are 40lbs too heavy is hard. Most people who try it fail. This is true of weight watchers, being nagged by your spouse, having a personal instructor or being on Herbalife. Its true of all diets.

One of the dumbest arguments I have heard (made insistently by StocksDD amongst others) is that the turnover in Herbalife customers/distributors is enormous and therefore Herbalife must be evil or at least burning the customers.

I would love to see the customer retention rate scatter amongst Herbalife distributors (my guess is the average is low and the spread is wide) and say Weight Watchers (probably with a similarly low average and wide scatter). The people I have met who are the most convincing Herbalife sales people have lost a lot of weight and kept it off for several years. These people are I expect the exception. Turnover and failure would be the norm.


PS. I am not so sure how you can be profitable selling washing powder at $27 per kilo. Herbalife products may be overpriced compared to generic competition - but the amount that they are overpriced is relatively small. Amway is ludicrous - just look at this link. And for the life of me I can't work out how "community" adds value to "washing powder". This is obvious for dieting, cosmetics, and cooking equipment.


Tuesday, July 23, 2013

It was the night before Christmas... falsifying Bill Ackman's Herbalife thesis

It was few days before Christmas and Sahm Adrangi (from Kerrisdale Capital) pinged me (on Google Voice) asking if I had an opinion on Herbalife.

I responded: "why bother? Crowded short."

I knew a little about Herbalife. It was a multi-level-marketing scheme (MLM) selling mostly weight loss products. This was a scheme where instead of buying weight loss products from a grocer or a specialist shop I purchased them from a friend. And the friend could make money two ways - either by selling product to me or recruiting me to sell product to other people.

I have long held a distaste for MLMs seeing how Amway used to behave in Western Sydney. Amway sold overpriced crap to distributors who were a collection of no-hopers and recovering drug dealers. (Contra: I also knew a very successful Avon lady... and she convinced me that MLMs sometimes sold useful products well.)

That said, Sahm just told me to listen to the Bill Ackman presentation. Sahm is crazy-smart so if he tells me to listen to something I listen.

Anyway, I unfurled myself on the couch at work for three hours of (Bill's) self indulgence.

Bill Ackman's thesis about Herbalife is that it is a pyramid scheme, hence

(a) illegal,
(b) unsustainable, or
(c) both illegal and unsustainable.

He has several key slides to support this thesis...

First he makes out that people don't really know what Herbalife is. He uses comparable companies being Church & Dwight, Energizer and Clorox.

I confess to knowing few Herbalife products - so this was modestly convincing.

He then - using that piece of rhetoric asserts that Formula 1 is the only $2 billion brand that "nobody has ever heard of".

So far, so good. He does not assert the sales are not real though (because they are). Indeed he acknowledges the company is real and that the gross margins are superior.

Through a process of elimination he shows that the gross margins are not a result of superior product (its a commodity), superior technology (they do not have any), superior R&D (they don't do any) or any of half a dozen other reasons you might have superior margins.

After that he asserts (and then tries to prove) that the gross margin and indeed the whole business comes about because it is a pyramid scheme.

He uses an old Federal Trade Commission (FTC) definition of a pyramid scheme - and it is the definition which we will go with because this determines whether Herbalife is illegal (in the US anyway) and the FTC definition overlaps with what would commonly collapse as a pyramid anyway.

Here is the slide defining a pyramid scheme.

This legal definition is the core to the whole Herbalife story - so I will write it out:

If an organization sells goods or services to the public and the participants in the organization obtain monetary benefits from (1) recruiting new members and (2) selling the organization's goods and services to consumers, the organization is deemed a pyramid scheme if the participants obtain their monetary benefits primarily from recruitment rather than the sale of goods and services to consumers. [Emphasis as per Bill Ackman...]

In summary: real sales to consumers is kosher. Sales to distributors (and not to end consumers) are not kosher. A little of the latter is OK (the distributors do need to have some stock). A lot of the latter is not.

The critical question is how much are sales to consumers.

And here the question arises: what is a sale to a consumer versus a sale to a distributor. After all if a distributor buys the product for their own use they are considered a consumer. If the distributor buys it to sell it (and they are stuck with it) then they are a failed distributor. End consumption is what matters here.

Slide 119 asks this question fairly directly:

To quote:

How much product purchased by Herbalife distributors is actually resold to Retail Customers?

The next slide repeats the now infamous David Einhorn question on a conference call (the one that caused the stock to drop 20 percent). It is a question that Herbalife answered very badly...

Again I will quote because it is critical:

Question #1 from David Einhorn: "First 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?"
Answer: We don't track this number and do not believe it is relevant to the business or investors.
The full text of the Einhorn question and answer session is at the end of this post...

Bill Ackman does not state it - but the question was asked on 2 May 2012.

Anyway this is a terrible answer and left Herbalife open to the Ackman attack because a surprisingly large proportion of the sales are not to externals but to people who are signed up as distributors. Self consumption by distributors is a critical issue and the company said they did not track it.

Three weeks later Herbalife was in damage repair mode - trying to distance themselves from this answer. Ackman puts up several slides dealing with this - a typical one is repeated below...

Again - for completeness I will put up the Ackman highlighted sections...

"...the attempt of Herbalife 101 was to break the distributors into single and multilevel. Why? Because A, it is truly single, and B, nobody questions single-level, knowing that most people who are in single-level aren't in it to make a lot of money. They are in it for part time or it self-consumption. If you go back to the old Avon model, before they were multilevel, right, self consumption, not even an issue. It is not covered on the FTC's website. It is expected."
And later...
I think it has been misrepresented as the product needs to be consumed outside the network, which it does not. A, the FTC said it does not. But B, wehn you think of the 82% of people at single-level, which is, again, that is all they are, it is not even a consideration as a challenge to the model.
Essentially the company eventually answered David Einhorn by asserting that the single level distributors are basically self-consumers - and hence part of the consumption set rather than part of the distributor set.

And this is the critical question. If the single level distributors are distributors without end sales then this is a pyramid. If the single level distributors are really consumers then this is not a pyramid, is legal and probably sustainable.

The company clearly has some explaining to do. What they are asserting is that millions of people sign a 48 thousand word distribution agreement, pay a $55 fee to become a distributor and buy product then just consume it themselves anyway. Bill Ackman clearly thinks this is BS.

The company asserts they do this because if they sign up as a distributor they get a 25 percent discount. It makes their personal consumption cheaper.

Bill Ackman then asks the following (possibly rhetorical) question:

Again to quote:

Why would anyone pay $55 to get a 25% discount when Herbalife products are widely available online for discounts of more than 35%?

Ackman answers this question with the following slide:

Bluntly - and this is the critical step in his argument that "We Believe the Majority of Herbalife's So-Called "Discount Buyers" are, in Fact, Failed Distributors" [punctuation in Ackman original].

About this time Sahm Adrangi pinged me again. It was one of those classic Sahm Adrangi observations - super-smart but I don't think how smart he realized it was.

He said that Ackman's assertion is really funny. He was imagining billions of dollars worth of Formula 1 diet supplements sitting on people's shelves or in their garages unsold. They sell almost two billion dollars worth of Formula 1 per year - on my count roughly 120 thousand metric tonnes per year. Most of that is sold to "distributors" who may or may not be "discount buyers". If they are - as Bill Ackman asserts - "failed distributors" then maybe 50 thousand tonnes of this stuff are building up on shelves and in garages every year.

If that 50 thousand tonne per annum build up is real then Bill Ackman is right.

And if that 50 thousand tonne per annum build up is not real then Bill Ackman is wrong. He is falsified. The whole Bill Ackman thesis falls apart.

We at Bronte are really into our epistemology. We seek things that can falsify our thesis - and if our thesis does not conform to reality then it does not matter who we are (Bill Ackman or Richard Feynman) and it does not matter how smart we are, we are wrong. Indeed here is Richard Feynman explaining process...

Indeed this video (and you really should watch it - visitors by email should go to the blog) lays it out.

You make a guess. You calculate the implications of the guess. If those implications do not square with observation then the guess is wrong.

Ackman made a guess - the guess is that the "so called discount buyers are in fact failed distributors".

The guess implies that there is a 50 thousand tonne per annum build up of Formula 1 on shelves and in garages of failed distributors.

If that calculation does not conform to reality then Bill Ackman is wrong (and it does not matter who he is, how smart he is or how beautiful the thesis)...

Our attempts to observe the 50 thousand tonnes per annum build up...

At Bronte our version of investing nirvana is when we can find theses on which you can make or lose a lot of money. And then peculiarly we can design simple falsifiable tests. Sahm Adrangi (bless his brilliant soul) provided us our test...

Go find (or fail to find) that 50 thousand tonnes per annum build up...

To start I asked some Herbalife distributors (found via the internet) what their stockpile was.

The answers were so small that they could not possibly account for the necessary build up.

But I guess those are the successful distributors as they can be found via the internet.

So I tried to think like a failed distributor.

If I was a failed distributor I might have $2000 worth of this getting old on my shelf. I might (reasonably) want to recover some money. So I would sell it.

Where? Craigs List or Ebay.

If I found lots of desperate distributors - failed ones - selling it on Ebay then Bill Ackman is probably right. If there are no such people then Bill Ackman is wrong. Simple test. And I can do it for any city or country in the world from my desk at home. For example I could use a proxy server and log into Ebay in France and test there. Which is what I did.

Anyway here is an example - Craigs List, Chicago, complete Herbalife listing...

It is a grand total of six people, five of whom present as small time failed customer/distributors and one of whom is trolling for business as a continuing distributor. The small-time distributors have some opened product (as in I started this diet and it was not for me).

I have done this test for many cities - and I simply have not found the level of distress. However if you go to a city with a large Hispanic population you find a lot of adverts. Los Angeles has many but almost all of them are continuing distributors wanting to sell products. This is a typical advert:

This person has been advertising on Craigs List for some time.

There are also adverts pitching that if you "sign up with me" you can have a permanent 25 percent off your Herbalife products...

In other words they are pitching precisely the offer that Bill Ackman (rhetorically) thinks is implausible.

So far I have found nothing like the level of distress that would be implied if Bill Ackman's thesis is correct.

So I looked at Ebay. Linked is a typical seller... the seller has sold well over 2000 Herbalife items, all with a minimum price (typically a 35 percent discount to retail) and over a multi-year period. They often detail their use-by dates - and those use-by dates change over time (suggesting that the product was purchased at dates that also changed over time).

When you try to communicate with one of these sellers you work out the truth. They are higher-level distributors. They buy the stuff effectively at a 50 percent discount (or 42 percent discount) and sell it at a 35 percent discount and thus make a profit. They are not failed distributors. Instead they are discounters gaming the system by trying to capture the bulk of the profits of the chain.

I looked and looked. Honestly I did. And I could find no evidence of large sales at distress - the sort of sales that would happen if there were 50 thousand tonnes per year build up of unsold inventory in the hands of "failed distributors".

And so we have it. Bill Ackman had a thesis. I calculated the implications of that thesis (distress selling on Ebay and Craigs List). This observation did not accord with reality.

Therefore Bill Ackman is wrong. And it does not matter how beautiful Bill Ackman is, how smart he is, how rich he is, or whatever. He is still wrong. And there isn't any room for argument about it.


PS. Bill Ackman being wrong does not make the stock a great buy. Indeed Bill Ackman being wrong does not tell me the truth. I can't find the truth with any certainty. I can only falsify ... I have a series of theses about the truth but they are subject of other posts...

There could be one of hundreds of other things wrong with the company (and hopefully those are testable things).

But we can be certain of one thing: Herbalife is not a pyramid scheme in the sense promoted by Bill Ackman. We can take the 300 page Bill Ackman presentation and throw it out. Falsified...

And any journalist (Michelle Celarier) who continues to take Bill Ackman seriously on this issue has disconnected from reality.


Appendix - the full text of the Einhorn question and answer session

David Einhorn
I've got a couple of questions for you. First is how much of the sales that you make in terms of final sales are sold outside the network and how much are consumed within the distributor base?

Desmond Walsh
So, David, we have a 70% customer rule, which effectively says that 70% of all products is sold to consumers or actually consumed by 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. You know that we reported on this call for the first time, the number of commercial clubs around the world, which is in excess of 30,000. So that has given us visibility 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.

David Einhorn
So what is the percentage that is actually sold to consumers that are not distributors?

Desmond Walsh
So we don't have an exact percentage, David, because we don't have visibility to that level of detail.

David Einhorn
Do you have an approximation?

Desmond Walsh
So well, again going back to our 70% rule, we believe that it's at 70% or potentially in excess of that.

David Einhorn
Okay. What is the incentive for a supervisor to sign somebody up to become a distributor as opposed to -- if they're just going to consume it for themselves, as opposed to just selling them the product for the markup? How does the supervisor come out better?

Desmond Walsh
Sure. So I think there's 2 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 a greater retention of that customer/distributor because they are now earning a 25% discount. The second issue is that it preserves lineage. So obviously, if I sign you up, David, as a distributor, my hope and expectation is that based on the tremendous product result that you're going to achieve, that you will have friends and families go to you and say, gosh, David you look great, what are you on? You're going to respond and say I'm 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 would get and therefore, my greater likelihood of retaining you as 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.

David Einhorn
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 and make 50 points if he pays the full price. If he signs up as a distributor and buys it himself, he gets a 25% discount and I get 7 points as a royalty, is that how it works?

Desmond Walsh
No. You will get the other 25%.

David Einhorn
I'll get the 25% plus the 7.

Desmond Walsh
So unless you're earning royalties, you would simply earn the difference. So you're in a 50% discount, you're selling at a 25% discount. And so the difference between the 2 is your profit on that sale.

David Einhorn
Right. So if he signs up as a distributor and buys it for himself from Herbalife, I still get the 25%?

Desmond Walsh
That is correct.

David Einhorn
Okay, good. One last question. When you had your previous 10-K, you disclosed 3 groups of distributors at the low end. You called 29% self consumers, 57% smaller retailers and 14% potential Sales Leaders. And then that disclosure did not repeat in the subsequent 10-K. So I've got 2 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've stopped tracking or just stopped disclosing?

John G. DeSimone
This is John. The criteria for grouping distributors into different classes was based off of their volume purchases. And we make assumptions that people below are a certain volume weren't doing the business, they were buying self consumption. And I don't remember the exact amounts but I can get it to you after the call. It's how we delineated between the 3 classes. One of the reasons we took it out of the 10-K is a change in CFO for which to me, I didn't view it as valuable information to the business or to the investors. However, we can easily provide the exact same breakout going forward if you like. I could email it to you and to our investors. Again, I don't remember the exact delineation between the 3 classes but I can certainly get it to you. Our objective is to be completely transparent.

Wednesday, July 10, 2013

Bronte Capital is hiring

APPLICATIONS ARE NOW CLOSED. We received 270 plus - and we are finalizing a short list...

Now we have hired. Thanks for your interest.

We are a small, fairly rapidly growing hedge fund with a good record and very few staff. More precisely we are a long-value equity fund with an esoteric and successful short book on the side.

Our record is well into the top-decile for hedge funds globally – and we intend on keeping it there. We are idea driven and risk-management obsessed.

We are happier hiring outside the traditional hiring loop. A science background with genuine interest in investment for instance is preferred over investment experience. Some unconventional combinations (computer science and criminology for instance) will be looked on favorably.  

Most - but not all of the work will be directed to identifying short-sale candidates however an interest in more conventional value investing would be useful too.


Our short book involves mass diversification of frauds, fads and failures with an emphasis on frauds. 

We are looking for one (and maybe more than one) analyst to be based in Bondi Junction (Sydney) Australia. One hire must have high-level computer skills. If we fill that position we may select a second person on a broader skill set.

Our work place is intellectual, playful, casual. A core job requirement is to be able to tell us when we are wrong. We are not looking for sycophants - telling us what we want to hear is of no use if it is not telling us what makes money. There are other organizations where being political pays but this is not one of them.

The successful applicant will however probably be more implementation driven than us. [We are hiring in part to cover our weaknesses!]

You will need to be self-motivated. Hours can and will be long, but clothing casual and if you want to come into work late because the surf is good that will sometimes be OK. Performance and output matters considerably more than face time.

We expect that a successful applicant will eventually be an equity participant in the business.

As we run a global fund from Sydney a successful applicant can expect some international travel.

Our main requirement is for an analyst who is really interested in the stock market and has well developed skills in data management and computer systems development. We aim to develop some very large data sets which will help us identify likely candidates for short-selling globally. We already identify literally hundreds of short-candidates annually and we are currently short over 100 names. The computerisation of this process is our main medium term task. Much of our edge is in knowing what sort of attributes are indications of fraud or weak performance. It is this high level filtering and screening that we need to automate on the short side at this time. This will involve large data bases of relatively low frequency (daily or even monthly close, not ticks) but high granularity (every item on the financial statement, outstanding option positions, cost of borrow, short interest and availability).

Programming skills are a requirement. Experience with technology that allows structured queries and searches on datasets (financial and non-financial) are a major advantage.

A working interest in epistemology is also useful.

Applications by email via the blog email brontecapital@gmail.com - or through our website - www.brontecapital.com.


PS. This post will be removed when we have found the right candidate. I have no intention of being inundated with CVs forever.

PPS. I have not taken advice on Australian immigration law but my understanding is that the law requires that I actively try to recruit an Australian and - failing that - I may open the offer up more widely. This is the path that I am taking anyway (pending contrary advice). Remote work is possible - but personally I have been unsuccessful in the past trying to manage it - so it is unlikely.

Friday, July 5, 2013

Fraud/promote shorts versus valuation shorts

Mostly at Bronte we short frauds or promotes. Stuff where the management says X but X is not true. Sometimes X is a stretch (a stretch made by promotional management). Sometimes X is patently false.

Either way we can describe what we do. We find things where the market is deliberately misinformed and hence comes up with inaccurate prices. We think (on reasonable grounds) that we are smarter than a deliberately misinformed market - and we often are.

We can answer the question "what is it that we see that others do not?"

Sometimes (rarely) we do valuation shorts. [We have a few valuation shorts now.]

In a valuation short we are working on the same information as everyone else has. This makes me uncomfortable. There is an arrogance in suggesting we can analyse the information better than anyone else. We find it harder to answer the question of what we see when others don't and hence harder to justify the position at all.

Indeed often we have no idea what the others are thinking and when I do not know what someone is thinking it is hard to justify (or test) the view that they are wrong...

I think this is the explanation for the cliché in short-selling circles that shorting valuation is a poor game.

Anyway - I am uncomfortable because I can't describe my informational edge and I don't like thinking I am smarter than other people (as opposed to better informed than other people).

That is all.


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The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, 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.