Credit: Shutterstock photoBy Christine Richard :
Herbalife ( HLF ) says its business opportunity is "Fun, Simple, Magical," and calls its compensation plan one of the most generous in the direct selling industry. The company's army of global recruiters sells this plan in glossy slide show presentations to audiences in packed hotel ballrooms and in one-on-one back-of-the-envelope pitches in their neighbors' living rooms.
For years, Herbalife described the compensation plan as one that returned nearly three-quarters of a product's Retail Price to its distributors through a mixture of commissions and retail earnings. From the company's 2012 Annual Report:
In its 2013 Annual Report, Herbalife explained how a longstanding pact with its distributors regarding their compensation strengthened the company's business:
Yet, behind this façade of fair dealing, the economics of the business are drastically impaired.
How bad is it?
Buying Formula One in Panama
Here's an invoice for a 550-gram canister of Formula One ordered by a Senior Consultant (a distributor entitled to a 35% discount) in Panama:
We can see that his total cost (before taxes) is $24.48, and that Herbalife appears to suggest a Selling or Retail Price of $26.43.
Yet, if the distributor sells that canister of Formula One to a customer for $26.43, after purchasing it for $24.48, he will earn just $1.95. As a percentage of the Retail Price, that's 7%, not 35%.
What's going on here?
Misleading Income Opportunities
Below is a slide from a Herbalife presentation describing all the ways recruits can expect to earn money. [1] Retailing is the most significant source of income, according to the presentation.
In the same presentation, we can see that retail profits come from getting various levels of discounts on the product, which supposedly range from 25% to 50%. As distributors advance to higher levels in the marketing plan (by purchasing more Herbalife products), they obtain greater product discounts. Our Panama distributor is at the 35% discount level because he has purchased 500 volume points in a one-month period. Bigger discounts mean correspondingly better retail profit margins on each product sold. Simple enough.
But check out the fine print at the bottom of the chart, if you can read it:
What's "Earn Base"? If you guessed that it's a number Herbalife uses to shrink distributor income, you guessed right. But before we get into how it does that, it's worth understanding the origin of the Earn Base.
The Packaging & Handling Backstory
In the early 1990s, Herbalife started imposing a "Packaging & Handling" charge of 5% of Retail Sales on every distributor invoice. The charge increased over time, and by the beginning of 2013, it reached 7% of the total suggested Retail Price on every order.
These "Packaging & Handling" charges, along with a separate "Shipping" charge generated massive revenues for Herbalife. In 2008, the line items totaled $293.4 million; in 2009, they totaled $326.9 million; and in 2010, they reached $396.7 million.
Most of the money Herbalife charged its distributors under the guise of packaging, handling and shipping wasn't actually needed to cover packaging, handling or shipping. We know that because the Securities and Exchange Commission asked the company about it in this April 8, 2011 letter to CEO Michael Johnson:
Herbalife responded in this letter , dated April 21, 2011, revealing that its actual cost of boxing up and shipping products to distributors was just a fraction of what it was billing for:
That meant 85% of what the company charged its distributors to box and ship their products was pure profit.
Transferring Money to the Top
It turns out that Herbalife's top distributors were big beneficiaries of these egregious charges. Shortly after the company implemented the 5% "Packaging & Handling" charge, it began paying out a 5% "Production Bonus," a second monthly payment on top of Royalty Overrides. Royalty Overrides are calculated on purchases made by distributors three "active" levels down from the recipient. The Production Bonus, which is reserved for a select group of the company's top recruiters, is calculated on purchases going down a potentially infinite number of levels.
It's worth mentioning that not all multi-level marketing companies offer these infinite payments, which critics say are a hallmark of pyramid schemes. When Avon Products resigned from the Direct Selling Association in September 2014 over concerns that the trade group was not implementing appropriate consumer safeguards, it specifically mentioned that it did not promise its distributors commissions on more than three levels of distributor purchases.
A lawsuit filed in the late 1990s against Herbalife by distributors Clint, Mary and Dan Fallow claimed that the Packaging & Handling charge was created to fund the Production Bonus, or "infinite bonus":
Herbalife management stated in the company's 1994 10-K that it introduced the Production Bonus "without a commensurate cost to the Company."
In other words, the "Packaging & Handling" charge was actually the Production Bonus levy, nothing more than a transfer from the rank-and-file distributors at the bottom of the pyramid to those at the top.
Creating the "Earn Base"
Fast-forward to 2013. Herbalife's business practices were under increasing scrutiny, and the company began implementing a series of changes that it dubbed its "Build it Better" initiative. Among these changes, Herbalife eliminated the "Packaging & Handling" line item from distributor invoices.
"Packaging and Handling (7%) has long been a difficult topic for Distributors to explain and Customers to understand," Herbalife said in a notification to its distributors in April 2013, describing its plan to do away with the charge.
But "building it better" did not mean eliminating the money transfer. It meant making it a bit less obvious.
Here's how: In a document, entitled "Simplified Pricing Structure," which Herbalife made available on its distributor website and you can see here , the company explained the change. The Packaging & Handling line item was removed from distributor invoices; the "Shipping" line item was renamed "Shipping & Handling," and it was increased by around 1%; and Retail Prices were hiked by about 5% across the board. Presto! The offending and confusing charge was eliminated, while Herbalife still collected the same amount of revenue from its distributors.
There was a snag, however. By moving most of the revenue previously collected via the Packaging & Handling charge into a Retail Price hike, Herbalife threatened to reduce the funding for its Production Bonus, or "infinite bonus." That's because distributor discounts and commissions were figured off Retail Prices; a higher Retail Price would mean bigger discounts and higher commissions for all distributors and less money to pay the Production Bonus.
So how did the company deal with that?
Herbalife's Perplexing "Simplification"
Before we launch into the explanation, I just want to remind the reader that Herbalife billed this 2013 change as a "simplification."
The company offers this slide from its compensation presentation:
We can see that the distributor's cost (with 25% discount) is $85.
And we can see that the Retail Price for the product he purchased is $110.
So if he bought the product at $85 and sells it for $110, he will make $25.
But that's not 25% of $110.
We would have expected him to earn 25% of $110, or $27.10, the implied profit margin potential that it pitched to recruits.
Right on the slide it states:
That just isn't true. He may be earning 25% of something when he sells at the Retail Price, but it's not 25% of the Retail Price.
So how in the world did Herbalife determine the distributor's disappointing discount?
After spending some time puzzling over the number, we determined that Herbalife executes the following mathematical gymnastics to come up with a distributor's discounted price: The company takes 25% of the Earn Base and then subtracts that number from the Retail Price to determine the distributor's discounted cost. That's a double whammy for the distributor, because it figures his discount off a smaller number and then subtracts that off a larger number.
Here's how Herbalife determined the distributor's after-discount price on that canister of Formula One purchased in Panama:
If you're feeling confused at this point, don't worry. I suspect that's the point. It's easier just to believe that you're getting a 25% discount off the Retail Price that will allow you to earn 25% of the Retail Price anytime you can actually retail a product to a consumer. It's easier to believe that, because Herbalife recruiters are constantly telling you that's how it works.
In summary, the Earn Base exists to shrink a distributor's discount, which is the final and necessary part of Herbalife's "simplification" of its pricing structure. The company hid the funding for the "infinite bonus" payment in the Retail Price in 2013, and then created Earn Base to shield that revenue so that it could all be paid to its top distributors.
If only our distributor's problems ended with Earn Base. They don't.
Charges On Top Of Charges
Herbalife further impairs the economics of its distributors' businesses by layering other charges onto their bills, particularly overseas, where the company is under less scrutiny.
The key to these charges is that they are added to a distributor's bill after the distributor's discounted product price is calculated (in the same way Packaging & Handling used to be added before Herbalife implemented its Earn Base gymnastics). That means these charges aren't part of the base off which discounts and commissions are figured.
Let's go back to our Panama invoice.
Two charges are added on top of the distributor's "discounted" price: a Shipping & Handling charge of $6.21 (GastosRetiro/Envio) and a Marketing Fund fee of $.49 (Fondo Marketing). These two charges add 38% back to the distributor's "discounted price" ($6.21+$.49 = $6.70) ($6.70/$17.78 = 38%).
We asked a distributor to check on what exactly this Marketing Fund fee covered. After a call to distributor relations, he informed us that the charge is about 2% of the Retail Price, and that it gets paid to Jaime Penedo, a Panamanian soccer star who plays for LA Galaxy and endorses Herbalife products.
How does Herbalife justify segregating this charge from its overall price? Are distributors expected to itemize this charge for their retail customers?
These extra fees are common. In some countries we researched, Marketing Fund fees go toward funding Extravaganzas and other Herbalife corporate promotional events, we were told. That also seems surprising given that distributors who attend these events are charged admission, so those who actually avail themselves of the events are paying for them already. How does the company justify adding these payments to all distributor bills, let alone to the bills of what it says are its many discount consumers?
Falling Short in 10 Countries
Such charges also help explain why distributors retailing in Panama don't come close to earning the 35% retail profits a Senior Consultant might reasonably expect.
They're not alone.
Herbalife imposes various fees, in addition to Marketing Fees, depending on the country. These include "Logistics" fees, presumably for moving the products around, in addition to shipping them. "Pick up & Handling" fees are imposed on distributors who forgo delivery and opt to go to a Herbalife warehouses, wait in line, pack the product into their cars and drive it back to their homes or Nutrition Clubs. Shipping costs in some countries can add nearly 50% to a distributor's bill.
As a result, in all 10 of the countries we looked at, the company falls short of delivering a 35% discount to Senior Consultants who sell at Retail Price.
In the fine print, Herbalife hints at the problem. Back to this slide:
The fine print states:
It's one thing to footnote that a distributor might incur extra costs as part of operating his or her business (say, home office expenses or gas), while failing to estimate the costs in a presentation showcasing the economics of the business opportunity. It's quite another for Herbalife to exclude its own easily quantifiable charges from the projections.
The company fails to disclose important and inclusive product cost metrics to its members and potential recruits during presentations and in marketing materials. By embellishing and overstating the potential profits - particularly profits related to retailing - Herbalife misleads the public about the most basic aspects of its business opportunity.
Willfully Ambiguous Disclosure Benefits Herbalife
It's possible to quantify that embellishment. To put a number to how much this misleading promotion transfers from rank-and-file distributors to Herbalife and its top distributors, we looked at the economics of the purchase of a 550-gram canister of Formula One by a Senior Consultant in ten countries.
These figures measure how the use of Earn Base rather than Retail Price to figure discounts impairs a distributor's retailing profits. The figures also take into account all the additional surcharges that inflate a distributor's cost above the discounted price and require him to absorb these costs if he sells at Retail Price. We also look at how the use of Earn Base rather than Retail Price to figure Herbalife-paid commissions to upline distributors on the purchase of one canister of Formula One reduces those payments.
Country
The Amount Distributors are Shortchanged Per Volume Point
Bolivia
32 cents
Guatemala
41 cents
Colombia
37 cents
USA
35 cents
Panama
33 cents
Russia
27 cents
Botswana
22 cents
Slovenia
17 cents
Peru
14 cents
Ukraine
10 cents
Conclusion
In summary, Herbalife uses excessive fees and convoluted math to reduce the income of its rank and file distributors by at least 10 cents and as much as 41 cents for every volume point they purchase. Taking a midpoint of 25 cents and spreading that across the 5.337 billion volume points Herbalife sold in 2013 suggests the company's misleading presentation of its compensation plan is worth about $1.3 billion a year to Herbalife and its top distributors. To put that in perspective, the company reported total worldwide net income in 2013 of $528 million.
There's an easy solution to this convoluted mess. The Retail Price should be the distributor's touchstone. Commissions and discounts should be figured off this number, and it should include all the costs that a distributor is expected to pay - with the exception of taxes, which vary based on where a distributor lives. Herbalife needs to admit that the profitability of its business opportunity is different in different countries, and that the potential income for those selling at Retail Price is far lower than advertised.
Instead, Herbalife targets low-income people around the world with what it says is one of the most generous direct selling opportunities in the business. It presents its business opportunity as a "solution for these tough economic times." Then, its top promoters use misleading discount and commission percentages to convince people that pursuing Herbalife's business opportunity will allow them to secure their family's future.
Is Herbalife's new motto "Build it Better" or "Buyer Beware?"
There really is no way for Herbalife to "Build it Better" and report half a billion dollars a year in profit. The company can't afford to be honest with its distributors about the most basic aspects of the business: the discounts, the commissions, and ultimately, the economics of being a direct seller of its products.
It's hard to find much about the Herbalife compensation plan that is "Fun, Simple and Magical." Instead, the plan might more accurately be described as "Disappointing, Complicated and Deceptive."
Christine Richard is the President of Orion Research LLC, which does investigative research for investors. She is a former reporter with Bloomberg News and Dow Jones and the author of Confidence Game: How Bill Ackman Called Wall Street's Bluff(Wiley, 2010). Pershing Square Capital Management, which has a short position on Herbalife, is a client of Orion Research LLC.
[1] The slide demonstrates how distributors have the potential to earn 73% of the Retail Sale price on a transaction. As an example, a Supervisor making a purchase of products with a Retail Price of $100 would receive the maximum 50% discount and presumably receive the maximum retail income of 50%, or $50. There is no wholesale commission in this case, because the Supervisor is entitled to the full discount. Other earnings related to this transaction go to the purchaser's upline: 5% is paid to each of three consecutive active Supervisors in his upline, for a total of $15. Upline Supervisors split an additional 7%, or $7, in Production Bonus payments, based on their standing in the marketing plan. Finally, 1%, or $1, will be paid in a Mark Hughes Bonus on this sale to distributors at the very top of the marketing plan. That brings the total profits to $50+$15+$7+$1 = $73.
Additional disclosure: The author does not take positions in companies she researches. Pershing Square Capital Management, which has a short position on Herbalife, is a client of Orion Research LLC.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
