Yesterday the stock of Herbalife (NYSE:HLF) dropped 20 percent when David Einhorn of Greenlight Capital began asking questions during the company’s earnings call. Herbalife is a multi-level marketing company which sells vitamins. The company describes itself:

We pursue our mission of “changing people’s lives” by providing a financially rewarding business opportunity to distributors and quality products to distributors and customers who seek a healthy lifestyle. We are one of the largest network marketing companies in the world with net sales of approximately $3.5 billion for the fiscal year ended December 31, 2011. As of December 31, 2011, we sold our products in 79 countries through a network of approximately 2.7 million independent distributors.

Despite its claims of being “financially rewarding” for its distributors, the evidence shown otherwise. MLMs in general are bad deals for distributors, resulting in financial losses for almost all of them. Court certified expert on multilevel marketing Robert FitzPatrick has researched these companies for years, and has found (emphasis mine):

A statistical analysis of income disclosures made by 10 major multi-level marketing (MLM) companies and the largest of all MLMs, Amway/Quixtar, reveals that, on average, 99% of all participants received less than $10 a week in commissions, before all expenses. Additionally, the report shows that on average no net income is earned by MLM distributors from door to door “retail” sales. Total losses of the participants exceed $5 billion each year, if only the entry fees, basic business expenses, marketing “tool” purchases and the pyramid commission portion of their product purchases (about 40% of their purchase price) are totalled.

The data analyses prove that virtually all MLM participants never earn a profit and that MLM claims of a broad-based MLM “income opportunity” are false. The report reveals that the majority of all commission payments are awarded only to a small group of promoters at the top. More than 50% of all commission payments were transferred to the top one-percent in ten of the eleven companies. In several cases, more than 70% of all commissions were paid to the top one percent. The top-loaded pay plans of the MLM companies are based on “endless chain” recruiting in which the investments of the latest recruits are transferred to the earliest ones, and the vast majority of all participants are always situated at the bottom levels of the chain, where profit is impossible.

The MLMs sustain their operations by annually churning 60-90% of all participants who quit the schemes and stop purchasing the MLM products after suffering financial losses. The schemes maintain the myth of income opportunity partly by convincing the churned victims that their financial losses were their “own fault” thereby making it possible to replace them with new hopefuls, who are unaware of the loss rates and the flawed and untenable structure.

The companies studied include Arbonne, Cyberwize, Free Life, Herbalife, Melaleuca, Nikken, Nuskin, Reliv, Usana and Your Travel Business (YTB). All data analyzed were published by the MLMs themselves, though presented in difficult to decipher formats. The analysis organizes the data in a uniform format for each company that is easily understood and compared.

Retail Sales to Third Party Customers

The questions David Einhorn raised are not new, but they are very important. He started by inquiring about actual retail sales of Herbalife products:

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.

So Herbalife has a “70% customer rule.” Do they monitor it? Do they enforce it? Is there any follow-up whatsoever? Likely not. They admit they have no way to know.

And included in this fabricated 70% figure is consumption by distributors. Herbalife admits it has no idea how many of the products it sells to distributors are sold to actual customers, versus how many are stockpiled by distributors who make the purchases to qualify for commissions (and hope that someday they may be able to sell them).

On the one hand, this might be legitimate because consumed products are consumed products. On the other hand, I think it is important to separate out consumption by distributors because it is important to know the actual third party sales, and because distributors may only be consuming because they bought products they haven’t been able to sell.

The evidence against any substantial retailing by distributors to third party customers is alive and well.  FitzPatrick reported earlier this year:

Evidence of Endless Recruitment, Not Retailing
What is the evidence that Herbalife has virtually no retail customers and is merely transferring the investment money from new recruits to earlier ones, dooming more than 90% always to lose?

• Herbalife cannot offer concrete evidence that it has retail customers. It says it does not track retail buyers. It cannot document how many there are or who they are or anything about them.
• The high and rapid drop-out rate of the salespeople would make it very hard for many Herbalife salespeople ever to develop retail sales. Retailing takes time to find and build a repeat customer base.
• The basic statistics that Herbalife discloses to the US government appear to show that retailing cannot be occurring on any significant scale. For example, the overall average purchases of all the salespeople is only about $190 a month. New recruits make 25% gross profit on retail sales. That would be less than $12 a week retail profit, before costs are deducted. Earlier recruits (leaders) make a higher percentage gross profit, but still the amount could hardly justify the time and costs on such a small volume of annual sales, based on their personal purchases.
• Then, there is the matter of Herbalife’s recruitment-based compensation plan that requires or induces large upfront purchases from new “leaders,” as much as $3,000. It also offers up to 33% of the payments made by recruits to the recruiters in “bonuses and royalties.” Under that plan, Herbalife could gain nearly half its entire annual revenue just from the large upfront investments of the consumers they persuade to join as “leaders.” Then, it could get the rest from the investments that the leaders pull in when they recruit “non-leaders.” The rewards for recruiting are far more lucrative than what might be gained from retailing. In short, Herbalife can operate for years only from the investments of salespeople without any retail sales at all. The business model and pay plan appear to be based on gaining investment money and making recruitment payments, not on generating retail sales.

Recruiting Versus Selling Products

Einhorn then went on to ask about recruiting versus selling:

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.

Not much information is provided here. I think the real issue is whether the company is more interested in selling or recruiting. Look at just about any MLM, and you will see that the main focus is recruiting. The product is simply the “cover” for the recruiting activities. The product is presented as the means to earn money, and as the “legitimate” part of the process (so as not to be described as a pyramid scheme).

Yet when it comes down to it, distributors in MLMs have difficulty selling enough products to earn any real money. It is almost always impossible to gather a large enough customer base to make a living from product sales, so the distributors turn to recruiting other distributors… hoping that they will recruit more, and they will recruit more, in an endless chain of recruiting. The original distributor is trying to earn a living by continuous recruitment below him.

While this makes mathematic sense (earn money on your downline!), it makes no sense in reality. There is always a large group of people at the bottom of the recruiting chain who can’t make much money without continuous recruiting themselves. This recruiting creates another level of people who can’t make much money unless they recruit, and so on.

FitzPatrick writes:

The total revenue of the eleven companies [studied] exceeds $12 billion. Approximately 9 million consumers worldwide invest in these schemes each year as “sales” representatives though little of the products are ever actually resold to end users. The newly recruited salespeople become the de facto and unwitting end-users. Their own direct purchases and fee payments represent nearly all the companies’ revenue.

With at least 60% churn rates, at least 6 million new people are enrolled in the schemes each year. The annual recruitment of these six million consumers is based largely on the companies; false offers of an “income opportunity.”

All nine million consumers sign legally binding contracts as independent contractors for the MLM companies, enabling them to participate in the schemes’ “business opportunities.” The contracts authorize them and provide incentives to potentially earn income from selling the companies’ products and from recruiting other sales representatives into the schemes.

And a Belgian court rejected the idea that retail customers are a primary goal for Herbalife. In ruling that Herbalife was a pyramid scheme, the Belgian court said that the goal of Herbalife was the recruitment of new distributors, not the sale of products to outside customers (see point #19).

Potential Sales Leaders (Supervisors)

Einhorn’s questions turned to the disclosures made by Herbalife:

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 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 reason 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.

The classification of distributors (who are not sales leaders) into the categories of discount buyers, small retailers and potential sales leaders is important. DeSimone states that the classification is done based on the purchases of the distributors. Those purchasing very small amounts are deemed to be purchasing for personal consumption. This number is important because it gives us a clue about how many distributors are selling to third party customers.

FitzPatrick criticizes the disclosure on this item from the 2010 10-K, saying that it is incomplete (and therefore meaningless) because of what it does not tell the reader:

Read that statement closely. You will realize that, while seeming to clarify the fundamental nature of the business, Herbalife does not reveal anything at all. Percentages of “orders”, not the sales force, are provided. But percentages (29%, 57% and 14%) of what orders? All company orders? The percentages add up to 100%. But, 100% of what? Obviously it cannot be 100% of all orders, since they only refer to the orders of the “non-leaders.” So, if it is percentages of orders among only the non-leaders, how much of the total orders does that that sector represent? Not disclosed. Well, then, how many salespeople are in each “category” who produced these percentages of orders? Not disclosed.

The data, at first reading, seem to reveal a precise amount of orders that are “self-consumed” by one group of sales people (and therefore not retailed) or sold only to a few family and friends of another group (producing very little retailing). But without disclosing the size of these “categories” or the percentage of total company orders they produce, the data, in fact, disclose nothing at all.

Even basis for these “categories” – discount buyers, small retailers and potential sales leaders – is not disclosed. Herbalife only reports that the categories are “based on their product order patterns.” What patterns? Not disclosed. Herbalife, in other words, discloses no verifiable or quantifiable evidence related to retailing. Yet, as the Belgian court ruling and the previous class action lawsuits have shown, this is the critical factor that determines whether Herbalife is a sales company or a fraudulent pyramid scheme. That factor is carefully and cleverly hidden.

Even still, there is at least something to be learned from the disclosure, or lack thereof.

The disclosures of these numbers were as follows in recent years, with the referenced categories of  discount buyers (customers who have signed up as distributors to enjoy a discount on their purchases), small retailers (product users and sales people who generate modest sales to friends and family), and potential supervisors (distributors who are proactively developing a business with the intention of qualifying to become a supervisor).

The 2007 10-K discloses:

In 2007, excluding China, distributor orders for these three general categories were approximately 52%, 26% and 22%, respectively.

The disclosure in the 2008 10-K states:

In 2008, excluding China, distributor orders for these three general categories were approximately 51%, 29% and 20%, respectively.

And in the 2009 1o-K Herbalife discloses:

In 2009, excluding China, distributor orders for these three general categories were approximately 47%, 36% and 17%, respectively.

The disclosure in the 2010 10-K reads:

In 2010, excluding China, distributor orders for these three general categories were approximately 29%, 57% and 14%, respectively.

And in the 2011 10-K Herbalife discloses no numbers for this metric.

Following the conference call, Herbalife made the following disclosure for 2011:

For complete transparency, however, the full year 2011 information is as follows:

• Discount buyers were 27 percent (distributors who receive a 25 percent discount);
• Small retailers were 61 percent (distributors who receive a 35 percent discount);
• Potential supervisors were 12 percent (distributors who receive a 42 percent discount)

Why might the recent non-disclosure in the 10-K have happened? You can see that the number of potential supervisors has been falling each year, to a low of 12% in 2011. This “potential supervisor” pool is where Herbalife depends on its growth.  The company lives and dies by recruiting, and if the number of potential supervisors (people who are hoped to be recruiting in future years) is only a little more than 50% of the number from 4 years ago (with a steady decrease in the years in between), there is a problem. Herbalife’s prospect for future recruits is shrinking.

Distributor Turnover

This is not the first time an important metric was left out of the 10-K, despite previous disclosure. A long time ago, Herbalife disclosed in its SEC filings the turnover rate of distributors. This includes the distributors were were not “supervisors” or “sales leaders.”

In the 2004 10-K, Herbalife disclosed:

For the latest twelve month re-qualification period ending January 2005, approximately 60 percent of our supervisors did not re-qualify and more than 90% of our distributors that are not supervisors turned over.

Herbalife’s 2005 10-K reported:

For the latest twelve month re-qualification period ending January 2005, approximately 60 percent of our supervisors did not re-qualify and more than 90 percent of our distributors that are not supervisors turned over.

And then suddenly the 10-ks included no such disclosure on distributor turnover.

The 2006 10-K only says:

For the latest twelve month re-qualification period ending January 2007, approximately 42.5 percent of our supervisors re-qualified.

The 2007 10-K discloses only:

For the latest twelve month re-qualification period ending January 2008, approximately 41.0% of our supervisors re-qualified.

The disclosure in the 2008 10-K states:

For the latest twelve month re-qualification period ending January 2009, approximately 40.3% of our supervisors re-qualified.

And in the 2009 10-K Herbalife discloses:

For the latest twelve month re-qualification period ending January 2010, approximately 43% of our sales leaders re-qualified.

The disclosure in the 2010 10-K reads:

For the latest twelve month re-qualification period ending January 2011, approximately 49% of our sales leaders re-qualified.

And for the 2011 10-K Herbalife discloses:

For the latest twelve month re-qualification period ending January 2012, approximately 52% of our sales leaders, excluding China, re-qualified.

The disclosure on distributor turnover may well be the most important disclosure the company could make. While Herbalife touts that at the end of 2011 it had 2.7 million distributors, with 548,000 of them “sales leaders,” it doesn’t tell everyone that more than 90% of the 2.152 million must be replaced in 2012 (if turnover is in line with historical reports of such).

Non-disclosure of distributor failure rates is not a new problem in the MLM industry. FitzPatrick notes from his research:

MLM companies seek to obscure their devastating failure rates by disclosing the number only of “active” participants and limiting the income figures to a one-year or even shorter time frames, thus concealing the factor of the ongoing and mounting losses of new participants. If all the participants over a five-year period are included in the calculations, the failure rate rises even further. Less than one in one-thousand will be shown to have gained any profit at all. The so-called successes in MLM are in the same small group positioned, year after year, at the top of the recruitment organization.

Two Non-Disclosures Together

Put the non-disclosures from the 2011 together, and you have a serious problem. 90%  of the sales force must be replaced. More must be recruited if the company is to grow the distributor base. Yet the number of potential supervisors (those who Herbalife hopes will begin recruiting) has dropped to only 12% of the non-sales leaders.

How will Herbalife grow when these numbers are dropping?

Herbalife said it is focusing on “daily consumption business methods” and its nutrition clubs. They must focus on finding distributors who want to be customers, because obviously the metrics surrounding distributors who want to be recruiters are falling. But how long can Herbalife sustain growth through distributors who only want to be consumers?

Herbalife’s Response

Herbalife pooh-poohed Einhorn’s questions, saying in a statement released after the earnings call:

The fact that recognized short seller David Einhorn asked questions on the call put pressure on Herbalife’s stock price.

To be clear: Mr. Einhorn’s questions raised no new subjects or concerns. They were elementary questions usually asked by investors new to our industry. These are issues that have been thoroughly addressed before. Analysts and investors can review the specific answers to his questions on our website later today at www.herbalife.com.

Our business fundamentals are very strong and we are confident in our financials, our disclosures, and our network marketing business method.

We believe the drop in Herbalife’s stock price today is a buying opportunity given the strong business fundamentals and our outlook for ongoing success. We currently have $428 million in repurchase authorization.

An “analyst” also downplayed Einhorn’s questions:

Following the plunge, at least one analyst thinks the stock has become a screaming buy. In a research note published after the conference call, Timothy Ramey, an analyst at D.A. Davidson, said the selloff in Herbalife shares has created “a major buying opportunity.”

He attempts to downplay Einhorn’s probing as a couple of “basic questions” about the company’s relationship between an independent customer and a distributor.

“If anyone else had asked the question we would have wondered why time was being devoted to such basic inquiries,” Ramey says.

I disagree with the characterization of David Einhorn’s questions as those of an uninformed newbie. They might have appeared elementary, but were in fact questions that go right to the heart of Herbalife’s business.

You can bet that David Einhorn has a whole lot of other things up his sleeve. This is just the beginning. He has likely been researching and investigating Herbalife for months, and my money is on Einhorn coming out with more damaging questions and information.