Who are Herbalife’s customers?
A fair question, yes. An innocent one, not at all. And answers came there… well many, actually.
The question has been loaded and pointed at the Los Angeles-based maker of nutritional diet shakes many times since David Einhorn appeared on an earnings call in May 2012. It is the polite way of inquiring whether Herbalife
has stopped beating its wife, is actually a pyramid scheme.
But the answers have not been conclusive. So let’s take a tour of the company’s responses, with the aim of showing why the question should continue to be asked.
First though, a quick reminder of why the identity of Herbalife’s customers is so crucial to the question of whether it is a pyramid scheme — something which the company denies and has said is based on a misunderstanding of its business model.
We have laid out before the underlying case law surrounding pyramid schemes in the US. The courts have repeatedly taken the view that someone is either a participant in a pyramid scheme (known as a distributor, in the jargon), or a customer of it.
That definition is crucial, because a company that makes the majority of its profits from putting products into the hands of willing customers is clearly legitimate.
A direct seller that makes most of its money from sales to recruits into its multi-level enterprise, however: that one deserves a closer look at its more triangular aspects.
Furthermore, if the law allowed for muddy waters between the two, then you would become extremely difficult to prosecute.
Who me, officer? I was just sampling the taste of the smoke. I would never inhale…
So what has Herbalife said about its customer base?
When noted hedge fund manager and short seller David Einhorn popped up on that earnings call, he asked what proportion of sales go to consumers who are not distributors. Herbalife President Desmond Walsh said:
So, we don’t have an exact percentage, David, because we don’t have visibility to that level of detail.
Asked for an approximation, he said potentially more than 70 per cent.
Then a day later, Herbalife lodged an 8K document with the SEC in which it gave some more detailed responses (our emphasis):
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.
Herbalife believes the majority of its distributors are discount buyers, who become distributors in order to purchase their favorite Herbalife products at a minimum discount of 25 percent (either directly from the company or from their upline distributor/supervisor). In addition, some of these distributors will also share with, or retail the products to other friends, family, and customers.
Question #3 from David Einhorn: “When you had your previous 10-K, you disclosed three groups of distributors at the low end. You called 29 percent self-consumers, 57 percent small retailers and 14 percent potential sales leaders, and then that disclosure did not repeat in the subsequent Form 10-K.
I have two questions; first, how do you track that and how do you characterise and know which ones are which? And second, why did you stop disclosing that in the last 10-K? Is that something that you stopped tracking or just stopped disclosing?”
Answer: We segment the distributors who have not attained the supervisor level into three general categories based on their product order patterns: discount buyers, small retailers and potential supervisors. We define discount buyers as customers who have signed up as distributors to receive a discount on their purchase; small retailers as product users and sales people who generate modest sales to friends and family; and distributors who are actively developing a business with the intention of qualifying to become a supervisor. We did not include the percentages from the 2011 Form 10-K in our more recent filings because we do not view the information as valuable to the business or to investors. 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)
The 27 per cent number for discount buyers — people who have paid $58 or more to receive a starter pack designed to help them grow a direct sales business, and signed the application form attached to the 124 page rule book for distributors, just in order to buy shakes and pills more cheaply — is consistent with previous financial disclosures.
Keep in mind also the unanswered part of the question — how do you know which one is which?
But back to the answers. In December Bill Ackman called Herbalife a pyramid scheme. Chief executive Michael Johnson immediately appeared on CNBC to explain why Mr Ackman was wrong, and he was again asked the question: what percentage of sales are outside the network?
90 per cent.
So the vast majority?
Yet a few weeks later, Mr Johnson was back on CNBC with a different message.
That was a misstatement, 90 per cent of our distributors, ok, who are buying our product, and let me just try to clarify this, buy it for one reason, they buy it for self-consumption, it was kind of a misstatement to that there. It was kind of hyped up that day wasn’t it?
The January interview coincided with a presentation from Herbalife designed to rebut Mr Ackman, one which relied heavy on market research from Lieberman Research (methodology undisclosed), which found that there are a good five or six million households in the US purchasing Herbalife products.
There was also a shifting of the argument and the emphasis, which introduces another piece of direct sales jargon, self-consumption. The Lieberman research found that not 90 per cent, or 27 per cent, but actually 73 per cent of people join Herbalife just to get discounts: they are self-consumers.
See, nothing to worry about here. It just looks like we don’t have customers because they and the distributors are all wearing green hats. If only we had thought to give customers blue hats instead. No wonder you were all confused.
For Herbalife’s part, it has said that its description of its customer base has remained the same over time.
Although there is no requirement to document or provide retail sales data, in line with its commitment to ongoing improvement and transparency, Herbalife has provided greater insight into the breakdown of its customer base and the motivations of those segments.
And it told the FT earlier this year.
The make up of the customer base is not at the heart of the question of pyramid schemes and it demonstrates a lack of understanding of the law to suggest it is. Rather, the deciding factor remains whether any payment is made for recruiting – Herbalife does not pay for recruitment; all payments are related to the sale of Herbalife products.
Now, explicitly paying for recruitment would be a rather obvious way to run a pyramid scheme, but not the only way. As we have described previously, the question is where the profits within the system are coming from, and whether that biases the scheme towards recruitment, which is why we think the make up of the customer base is important
So realise what this concept of self-consumption does to attempts to prove that a company and its top distributors have constructed a pyramid scheme.
At its heart, such a fraud is one that exploits its recruits hopes of making money, and lets them blame themselves when they fail.
If, after the fact, you can say that those people who failed to recruit their own distributors (or in the jargon, build their own downline) as self-consumers, you have magically turned victims into customers.
We have reached the subtext to Mr Einhorn’s question. How do you track that? How do you know the discount buyers from the budding entrepreneurs when they are all part of the same structure?
That problem is why the case law makes a distinction between participants and non-participants. There is no third category of self-consumption within the context of pyramid scheme law.
This is not to say that Herbalife is trying to hide victims — we simply cannot see the underlying data, and pyramid schemes are fact specific.
Rather it is to say that the answers to questions about its customer base are not sufficient to judge whether it is a pyramid scheme or not. Self-consumption, like pointing to the existence of a certification scheme, is a circular argument. Without the underlying details we cannot see if it is fig leaf or fact.
Herbalife says it is not a pyramid scheme, and responded to what it sees as a problem of terminology in July.
We know a large percentage of our distributors or participants are simply discount customers who use our weight management, nutrition sports, and personal care products primarily for their own use. Knowing that most of our participants are discount buyers, we have decided to change and simplify the terminology we use for participants in our network.
Beginning this quarter, the term we will use for participants will change from distributor to member. This change will require modifications to all participant agreements, rule and training materials and will take several quarters to implement across all platforms around the world.
They will be called members, but they are still participants. For those changes to be meaningful, there must be a clear and obvious distinction difference a member and an aspirant distributor, beyond the fact of different coloured hats.
Indeed, look again at that answer to Mr Einhorn’s first question again in this light, where Herbalife says that the majority of customers are discount buyers.
Herbalife believes the majority of its distributors are discount buyers… In addition, some of these distributors will also share with, or retail the products to other friends, family, and customers.
They are discount buyers, you see, except when they are not.
And finally, one puzzle remains. The argument for self-consumption means that company is in many respects a discount club.
Yet, historically at least, distributors do not look like loyal customers. In 2005 the company disclosed, with our emphasis:
For the latest twelve month re-qualification period ending January 2005, approximately 60 per cent of our supervisors did not re-qualify and more than 90 per cent of our distributors that are not supervisors turned over.
Churn in the supervisor ranks (know as sales leaders) remains high, but we can’t see the distributor churn printed in the more recent annual reports.
Perhaps Herbalife’s weight control products are so effective that former distributors are off leading happy, skinny, lives. Or, that churn rate has dropped significantly and Herbalife hasn’t mentioned it.
So, one more question. If three-quarters of the distributors are discount buyers who love the product, why don’t they stick around?