Bill Ackman's Analysis on Herbalife (Part II)

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Following the previous article on Bill Ackman’s analysis of Herbalife's (NYSE: HLF) tremendous growth within the previous 30 years and the irrationality of having a high product price with little R&D and marketing expenses, this article will summarize his analysis on the company’s business and remuneration models. Bill Ackman has shown that Herbalife claimed retail made up around two thirds of the profit for the distributors in the company, to convince that the retail opportunity was larger than recruiting rewards. There are four points, which should be made clear: (1) suggested retail price and actual retail price, (2) internal consumption and retail profit, (3) wholesale commissions and retail profits, and (4) the recruiting rewards were included in SG&A.

Suggested and Actual Retail Price

The surcharge of 7% was applied to all distributors of the company for packaging and handing on the Suggested Retail Price from Herbalife. In some other markets, more fees were charged such as administrative fees, freight charge, etc. Thus, in order to make a profit, all those additional charges need to be passed through to the end users. That would push up the true suggested retail price for distributors in order to earn “full retail profit.” However, according to Ackman, consumers can go online and purchase the products at around a 40% discount in the adjusted suggested retail price. One of its peers, GNC Holdings' (NYSE: GNC) products was identified to be sold on eBay for a 2% premium to the adjusted suggested retail price. In addition, GNC’s Lean Shake products were sold at similar prices to Herbalife’s Formula 1 (750g), which was more proof that those products were commodities. He came to conclusion that the Suggested Retail Price was artificially high, which was not related to the real price to be sold to the end users.

Internal Consumption and Retail Consumption

Internal consumption means the sales to the distributors including sales leader and non-sales leaders, whereas the retail consumption means the sales to the retail customers. David Einhorn has asked Herbalife about the sale made outside the network and sales inside the distributor base. Ackman quoted Herbalife’s answer:

We don’t track this number and do not believe it is relevant to the business or investors.”

Ackman wrote that the company believed that the majority of the distributors signed up just to purchase the products at the minimum discount of 25%. The model sounded similar to the membership model of Costco Wholesale (NASDAQ: COST). Indeed, in 2009, the CFO has mentioned that the two models were similar. However, comparing between Costco’s membership, GNC’s membership and Herbalife’s membership, it was quite different.


<img src="/media/images/user_14219/screen-shot-2012-12-21-at-83426-pm_large.png" />

Source: Business Insiders

The renewal rate for Herbalife was said to be around 10%, whereas Costco’s was 90% and GNC’s was 70%. The other two companies didn’t require any paperwork, whereas Herbalife offered a very long distributor agreement. If the products get returned, Herbalife’s membership would be lost, whereas the product return policies of the other two was much more flexible. 

Retail Profit and Wholesale Commissions

Bill Ackman pointed out that when the product was purchased directly from Herbalife from a non-sales leader, the transaction was accounted as if the sales leader purchased the product. Thus, the Wholesale commissions for sales leader was hidden in the Distributor Allowances in the company’s P&L. It was to increase the “retail profit” amount. According to Ackman, the Wholesale commissions should be accounted as recruiting rewards, and all the commissions paid to upline sales leaders should be accounted as operating expenses of the company.

SG&A Item Included Recruiting Rewards

In Herbalife’s income statement, Ackman said that the Distributor Allowances item included the Retail Profit and the Wholesale Commission, Royalty Overrides included Royalty Overrides, Production Bonus and Mark Huges Bonus, and SG&A might include Vacations and Promotions. Since 1997, the SG&A and the Royalty Overrides have moved side by side with each other. It was disclosed that, 15% of net sales in 2007, or 54% of the SG&A was “Distributor Facing” expenses in 2008 Investor Day of the company, and actually “Distributor Facing” was sort of Royalty Overrides.

In conclusion, Ackman came to the conclusion that with the reasonable assumptions, Herbalife distributors could earn an extremely small amount of profit, around $5 per month. In addition, whereas Herbalife’s presentation showed that the payout for recruiting rewards were only 31%, but when the internal consumption, retail price adjustment, wholesale commission and SG&A were taken into account, the recruiting reward payout was as high as 92%.

In the coming article, we will see how Ackman pointed out the misleading figures in the company’s statement about US supervisors’ compensation, the Herbalife business is actually really easy or not, and several red flags compared to other MLM’s companies. 

hoangquocanh has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco Wholesale. Motley Fool newsletter services recommend Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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