Monday, March 24, 2014
Peter Vander Nat - an economist for the FTC - has written a paper which gives Herbalife bears a lot of succour. He doesn't much like internal consumption. If Peter Vander Nat's paper is decisive then Herbalife will have a very tough time with regulators.
Dan McCrum - one of two consistently anti-Herbalife journalists - harps on about internal consumption as being the hallmark of a pyramid scheme. Here is yet another article.
And the most ardent Herbalife bull (and I am an ardent bull) must admit that a multi-level-marketing scheme where all the consumption is by people in the pyramid gives you pause. You have to ask where are the real customers? And if there are no real customers then surely it is a pyramid as a matter of fact (if not a matter of law). And pyramid schemes will eventually collapse on their own - they don't need the FTC to bring them down - even if government action speeds up the process. [And that is an important point - if the Ackman thesis on Herbalife is correct the government action doesn't change the end result - just the speed at which that result happens.]
But it is also clear that not all internal consumption is problematic. I have no problem with a young woman signing up as an Avon lady so she can buy cosmetics at a discount. I am sure plenty do. And if she takes half an hour putting on make-up in preparation for Saturday night - isn't that real consumption?
And I have spoken to several Herbalife customers and they are mostly signed up as distributors and they do not intend to sell product. They are signed up simply to get the 25 percent discount. Some even bulk up their orders between a few of them to get 35 percent discounts - but they still intend on making no retail sales except to themselves as a "buying club". Indeed when I went to the Herbalife in Queens I spoke to several people who were real customers and were proud of the weight that they had lost being repeat customers over many months. They were buying Herbalife at full freight from one distributor (the owner of the nutrition shop) and were themselves Herbalife distributors to buy product at a discount at home. These people never sold Herbalife except maybe a little to family members. But they still purchased Herbalife independent of their own distribution arrangement and clearly and publicly consumed it.
I should (overriding my bullishness) explore this - a crux issue in the Herbalife debate neutrally. I expect bears to comment - and I figure this will wind up being more than one post. So lets give an example of clearly bad internal-consumption and an example of clearly-good internal consumption. I am not saying whether either of these examples predominate or even exist within the Herbalife network - but just outlining what might be a very bad position for Herbalife or a very good position for Herbalife.
Whether the examples exist or predominate is a fact to be checked on the ground - not a theory to be hypothesized. The FTC I hope will check the facts on the ground rather than pontificate on theory.
But then I suspect the FTC will be better than many a Wall-Streeter. There are many people who have an opinion on Herbalife without doing their own research - and instead they borrow "facts" from convenient parties. Bill Ackman claims to have done a lot of research. I have done a fair bit and wound up at a diametrically opposed position. I don't expect you to take either of our claims seriously without doing your own research. We both have vested interests.
This post doesn't do the research for you. It outlines a process by which you can do it for yourself. There is very big money to be made here - Herbalife in the conception of the bears goes to zero. I think it goes well over $100 and probably eventually closer to $200.
This is a place where if you do the research you can know - and you can make a lot of money. But you also need to worry about the FTC deciding arbitrarily and - like much of Wall Street - not doing the research. [And that is a worry you need to have whether you are a bull or a bear. Arbitrary government decisions happen and they are not pretty.]
Anyway lets start with two examples:
Example A: Clearly bad internal consumption
If you are a Herbalife "Senior Consultant" you can get a 42% discount on your product if you place a single order of 1000 volume points. That 42% discount applies that month only. This is described in this video from a couple of very senior Herbalife distributors (the critical bit starts at 5:20):
This clearly encourages people to place one order - a "success builder order". And it is a pretty big order. A pack of Herbalife Formula 1 - the key diet shake product - is about 24 volume points - so the order would need to be over 40 packs of Formula 1 - each pack being 750 grams. With discounts the order is still around a $1000.
Now you could imagine a situation where an unscrupulous upstream distributor encourages someone to place such an order - explaining to them that this large order will make their margins 7 percent better (42 percent discount rather than 35 percent) and that 7 percent means that when they sell it to the throngs of waiting customers they will make more money.
And you could of course imagine that our hapless victim doesn't find the throngs of waiting customers - and is left with something like 30 kg of unsold (and in my opinion unpalatable) protein shakes and doesn't want to throw them out and so internally (ie self) consumes.
A "meal replacement" is roughly 60 grams - so our poor person either throws out their shakes, stores it indefinitely, starts selling it on EBAY or Craigs List in distress, or starts drinking very regular meal-replacement shakes. 30kg is 500 meals so they could self-consume this quite reasonably in two years.
But they may feel victimized. This would be bad internal consumption - inventory loading based on fraudulent business opportunities.
There are several defences to say this does not exist. Herbalife has a refund program for unopened Herbalife product sold to distributors - and the refund option lasts a full year. The refund does not include postage (so our victim will be out of pocket). Moreover the victim may not be aware they are entitled to a refund - and their upline will actively discourage them taking a refund as the upline will docked volume points. Moreover I have seen companies that overcharge for postage (postage as a profit center), and I have seen companies where it is almost impossible to cancel a contract or get a refund even if you are legally entitled. I have also seen companies where it is impossible to find details on the refund even when it clearly exists. So the facts of the refund need to be tested on the ground.
Whether these people exist or even predominate in the network is - of course - determined by facts on the ground. This post does not check the facts on the ground. It is thinking about things rather than actually doing those things.
Example B: Clearly acceptable internal-consumption
Very early in my Herbalife travels I met a Hispanic guy in a Herbalife club. He had been a customer for about twenty months. He had lost about 50 pounds and he would say to you with sincerity that Herbalife saved his life. He was signed up as a distributor.
He was sitting in a Herbalife club drinking a shake which he paid $5 for. This was the same price I paid for it - that is retail. This was real consumption - and he was not in the Herbalife club to participate in a scheme - rather he was there to chat with his friends and drink protein shakes.
My distributor had a job - and he had no intention of making a living selling Herbalife. His photo was on the wall of the Herbalife club as a success story - with gold-stars next to his name as he met weight targets.
Most breakfasts he came to this club on the way to work. He did it to chat with friends and the proprietor (who had become a friend if he wasn't a friend already). He was however a distributor as well - originally so he could buy the product for home consumption at a 25 percent discount though he had (being a true-believer in the product) sold some to product to friends and relatives. However that is incidental. Almost all the product he purchased he consumed himself.
But he is also clearly a real consumer - and he had come to the store maybe 200 times to consume and each time he had paid the same price a retail customer pays. His cumulative payments were over $1000. Over time I would expect him to spend a fair bit more than that.
This is technically self-consumption. This is product sold to an internal distributor - but it is very difficult indeed to argue it is problematic and Peter Vander Nat's assertions about the wrongs of self-consumption are clearly off the mark in this case.
The fact that this is an "internal sale" doesn't make the consumption any less real.
It has a characteristic that is important though - it is repeat business. Anywhere you see repeat business it is very hard to argue the customer is a victim. People get ripped off regularly - but they seldom go back to the same source to get ripped off again.
Perhaps the right question to ask is not the David Einhorn question of how much of the sales are to customers outside the base but how much of the sales are to repeat customers - and how often do they repeat. Repeat purchases by individuals are not consistent with inventory loading fraud even if the repeat purchases are internally consumed.
If the sales are to repeat customers then almost all of Bill Ackman's arguments fall apart.
Checking the facts on the ground
I know some people out there plan on actually doing due diligence. Here is a plan...
You could go and find a bunch of Herbalife distributors. Its not hard to do.
Get out an Android phone in any Hispanic-rich area. Ask it to navigate you to Herbalife distributors and start asking questions when you find them or do not find them. I did this starting at Avondale Arizona and took this screenshot. A similar screenshot in Corona New York is laced with Herbalife distributors.
If two days of legwork throws up a lot of people who may be internal consumption (they are signed up as distributors but drink the product) but that most of that internal consumption looks like my bad example then short the stock and send your detailed evidence to the FTC. [Send it to me too... I like knowing when I am wrong.]
If however the internal consumption looks like good internal consumption (repeat customers mostly) then Bill Ackman is wrong and it should be easy enough to convince the FTC that this is a real business and Ackman should be ignored.
I have met several customers who are true believers. They really believe Herbalife saved their life and it is a wonderful product - and they are mostly right. The cult-of-weight-loss shakes works for them. Herbalife has saved their life.
Herbalife's best defence is to get testimonies from more than 100 of them and send those testimonies to the FTC - or better get their customers to send the testimonies to the FTC. Before and after photos are good. If they get 1000 plus of these they win. After all 1000 plus people who have been in the meal-replacement game long enough to lose 50 pounds is good evidence of intended, deliberate personal consumption - and it shouldn't matter a jot whether the people are signed up as distributors. [Someone who actually loses 50 pounds is a real customer of a weight loss club no matter whether they work there or not...]
Short circuit this process:
There is a simple way of short-circuiting this process. You can for a few hundred dollars and some pain work out whether Herbalife is a pyramid scheme. Herbalife will hate me for saying this because it imposes costs on them.
The solution: sign up as a Herbalife distributor. Place a success builder order. See if all the information needed to get a refund is available easily available.
Try and get your refund.
If it is easy to get and they do not gouge you on postage then it simply cannot be an inventory loading scheme as-per-Ackman. For this to be a pyramid scheme you have to have literally millions of distributors stuck with unwanted inventory.
If the company offers and honours refunds to failed distributors then the idea that the whole scheme works by selling inventory to failed distributors is ludicrous.
If you do this take your position in the stock, send your information to the SEC and wait to profit.
Oh, and send it to me too. Always interested.
One for the observant
People who read my posts obsessively (and there are a few of you) may notice that in the screenshot above there is a Herbalife distributor in Botany Street Bondi Junction. Bondi Junction is not in Arizona, it is in Australia and it is where Bronte Capital has its offices. Its in there because I marked it in my personal Google maps.
The Herbalife distributor in that screenshot is United Online Business Systems - which isn't any old Herbalife distributor. It is the Australian arm of Shawn Dahl's distribution business. Shawn Dahl is the most infamous scummy Herbalife distributor - the one that sold leads and false business plans and is the centerpiece of most of Bill Ackman's examples. There is a very good story in the Verge about Shawn Dahl's business and Shawn Dahl was the first distributor Bill Ackman outlined when he started writing up the business of distributors.
It is kind of ironic that the iconic scummy Herbalife distributor is the closest Herbalife distributor to my office.
Shawn Dahl is no longer a Herbalife distributor. Herbalife kicked him out of their network. I could find no trace of his Australian office. [Fair point to Bill Ackman though: it took Bill Ackman before Herbalife got rid of Shawn Dahl. They should not have waited that long.]
Criticism where criticism is due
I don't normally criticize the press - but here I am getting a touch annoyed. The FT have written dozens of stories on Herbalife. The FT has journalists in dozens of countries. I am critical of Wall Street (myself included) for thinking about things but not actually doing those things. [I have spent a lifetime thinking about things without actually doing those things.]
I am double-critical of news organizations who report without leaving their desk and without checking the facts on the ground. But who - like me - are very good at theorizing.
The FT is uniquely placed to bring some rationality to this debate. One day they could send a journalist to a distributor in six or seven different jurisdictions. May I suggest (a) Corona New York, (b) Los Angeles, (c) Mexico City, (d) Kuala Lumpur, (e) anywhere in China, (f) Australia. KL is probably Herbalife's strongest market - so that is an important inclusion.
After doing this the FT will be able to answer definitively whether there are large numbers of real customers globally and those customers voluntarily consume the shakes because they want to consume the shakes, or whether the customers are just suckered distributors as per Bill Ackman.
It is however work - probably a day work for six journalists. But it is a great story - and real facts are the reason you buy the financial press.
I have done this mostly myself. However nobody will believe me because I have a financial interest in the results. Its time for the press to reassert itself as a conflict free arbiter of real data. For that I will gladly pay the several hundred dollars a year for the FT's strangely coloured pages.
PS. Dan McCrum - who seems to write most of the FTs stories on Herbalife - lives in London. London is strangely devoid of Herbalife clubs. I tried to find one to visit with Dan in London and flat-out could not. Herbalife in the UK ranks very low on Google Trends - and My Herbalife - which is the search you would do for the Herbalife distributor portal - barely ranks at all. Dan's location makes it very hard for him to do the checking on the ground his stories warrant. If there is criticism of Dan's work ethic it isn't meant. It is criticism only of location.
Wednesday, March 5, 2014
When I was in my twenties I worked for the Government of Australia and I watched the privatisation of Qantas fairly closely.
In those days the Finance Department swallowed the Qantas lobbying totally. What was good for Qantas was good for Australia.
In all seriousness bureaucrats who should have Australia's interest at heart were all for restricting competition on the Kangaroo route [Sydney-London] to keep Qantas's profits sweet. After all more profits meant a higher sales price.
Tourism those days was a huge industry - driven in part by the then low Australian dollar. Londoners came over by the plane load and tourism operators up and down the coast of Queensland were making hay.
What Qantas was arguing for was restricting their customer numbers.
If the average middle-income coastal town knew about and understood the issues they would have rioted. But Qantas obscured their self-interested bile by wrapping themselves in the Australian flag.
Little has changed except now the issue is the solvency of Qantas, not the sale price. Qantas has been so mismanaged it is almost the only airline in the world in financial trouble now. The rise in Chinese demand (including Chinese demand on say Shanghai-Sydney flights) has meant that fuel efficient aircraft are in short supply and any airline who has managed their fleet well is making excess profits. [Just look at the stock charts for US airlines.]
Qantas however has mismanaged its fleet to a degree that is now ludicrous. This week I will by flying Sydney to LA on a 777 - a two-engine jet. Qantas does the route on old 747s (four engine jets). These are tens of tonnes of fuel less efficient and Qantas is higher cost because of fleet mismanagement as much as anything else.
But the fleet mismanagement goes further. Decades of incompetence has left them with the most amazingly heterogeneous fleet in the world. This airline deserves to go bust.
But like the Qantas of old it goes to government who seem to think for some ungodly reason that the business is even important.
There will be other airlines after Qantas. They will be cheaper, have better service and use more fuel efficient planes.
And they won't believe that what is good for them is good for Australia.
It is time to let Qantas fail.
And just for the record: we are not short Qantas. But two decades later I retain my anger about their false patriotism.
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.