Herbalife, USANA and Big Shorts

David Einhorn, hedge fund manager for Greenlight Capital, rocked the MLM industry when he publicly asked Herbalife’s CEO about the company’s customer numbers.  During an earnings call, Einhorn asked, “So what is the percentage that is actually sold to consumers that are not distributors?”  Herbalife’s CFO, Desmond Walsh, responds by saying, “So we don’t have an exact percentage, David, because we don’t have visibility to that level of detail.”

Shortly after the conversation, Herbalife’s stock plummeted 20%, resulting in approximately a $1.7B loss in value.  Immediately, people in the industry perceived this as some sort of an attack on the industry.  It even prompted a statement from the DSA.  In the statement, the DSA defended the practice of paying commissions on internal consumption (full statement below).  Here’s the issue I have with the DSA’s reaction: Einhorn never questioned the legality of paying commissions on internal consumption.  It has already been established, time and again, that it’s perfectly legal to pay commissions on distributor volume.  Instead, Einhorn’s decision to short the stock was basically a vote of “no-confidence.”  Based on how he bet his money, he senses a weakness in a business with anemic customer numbers.  It was a simple question, he got a squirrelly answer, he jumped ship and a boat load of people followed.  I didn’t sense anything nefarious.  He’s a capitalist, perceived a weakness, took a risk by shorting the stock and made a lot of money.

UPDATE: July 10, 2012. As it turns out, Einhorn has NOT confirmed whether he has shorted the stock. When Herbalife’s stock value dropped, I assumed that he shorted it. But, as it turns out, the stock took a dive JUST BECAUSE Einhorn asked the question, which boggles the mind. If Einhorn announces that he’s short on Herbalife, look for a dramatic drop in value.

Customer data is important; however, the law does not require a certain percentage to distinguish good companies from bad.  After all, what percentage is adequate?  10%?  20%?  But, if Herbalife wanted to produce the percentage, I’m sure they had the means to do it.  I would agree that it’s impossible to produce an exact figure; however, a general sense COULD be provided.  Today, when the customer can go directly to a replicated website and order product, there’s certainly some concrete information that’s immediately available.  As for the people that sell product face to face, it’s not hard to do a survey of a segment of the sales force and / or require that people self-report their customer sales.  But, again, how much is sufficient?  It’s an question that remains unanswered.  And until a regulator or legislator publishes a standard, there’s no obligation to go there.

As for USANA, they got hosed

We’re dealing with a different set of facts with USANA.  In USANA’s case, Shortzilla, a popular site for short stock ideas, announced its short position on USANA stock shortly after watching the Herbalife drama unfold.  Instead of just asking a simple question and trading accordingly, the article on Shortzilla proceeds to make a lengthy argument that USANA operates as an illegal pyramid scheme; thus, justifying its decision to short the stock.  Check out Ted Nuyten’s site, Business for Home, for a complete report on the USANA short.  In the article, the author makes a number of factual assumptions and really mischaracterizes the legal standards distinguishing legitimate network marketing companies from MLMs.  The article smelled like it was outcome-determinative i.e. he wanted to trash USANA to further support the short position. The Shortzilla article, in my opinion, was a self-serving attack.

Conclusion

I’ve long been writing about the importance for strong customer numbers.  I’ve gone so far to write that we, as an industry, are deluding ourselves by pretending there’s not a problem.  Throughout my career in the industry, I failed to appreciate arguably the most powerful lever that will eventually lead to positive change: the market. While most companies in the space are not publicly traded, the ones that are will be pressured to provide some strong customer metrics in order to build investor confidence. Investors are getting educated.  Instead of re-hashing legal principles about the legitimacy of paying commissions on downline consumption, we need to be having a more serious conversation about ways to improve the space to improve confidence in the overall marketplace.

DSA’s Statement

WASHINGTON, D.C.—As the association representing more than 200 leading firms that manufacture and distribute goods and services sold directly to consumers, the Direct Selling Association (DSA) would like to set the record straight in response to questions raised about the direct selling business.

Unfortunately, even though the direct selling industry has definitively demonstrated the propriety of internal consumption to the regulatory community, stock prices of Herbalife and other publicly traded direct selling companies fell as a result of inquiries by hedge fund manager David Einhorn.

First and foremost, the direct selling business model is solid and strong. After falling slightly in the wake of the Great Recession, total industry sales grew nearly one percent in 2010 and are expected to show even stronger gains when 2011 numbers are announced in early June. Most publicly traded companies reported strong earnings and income in 2011.

Nearly 16 million Americans engaged in direct selling in 2011, some as full-time entrepreneurs seeking to build a business and some as part-time representatives hoping to earn a little extra money. Others sign up as representatives simply to purchase products or services for their own use at a discount and never sell to anyone else. Regardless of their income expectations, almost all direct sellers use the products themselves. This is what is known as “internal consumption.”

As the Federal Trade Commission (FTC) stated in a January 2004 Staff Advisory Opinion, internal consumption is not considered to indicate impropriety. Instead, “the critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture.”

In short, what the FTC watches for—and what the DSA Code of Ethics is designed to protect against—are compensation systems that are funded primarily or exclusively by payments made for the right to recruit other participants. Compensation must primarily be based on the sale of products and services to the ultimate consumer—whether or not that consumer is also a seller of the products.

Unfortunately, direct sellers have been targeted in the past by short sellers who have deliberately injected inaccurate information or rumors into the marketplace with the goal of driving down stock prices for financial gain. In the end, it is the millions of hardworking American direct sellers who suffer the results of these attacks while the perpetrators walk away with millions in profit. DSA exists to protect and promote the direct selling industry by educating policymakers, the business community and the general public about the nature of the industry and how it works; and ensuring DSA member companies behave ethically in all aspects of their businesses through enforcement of the DSA Code of Ethics.

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  • http://amlmskeptic.blogspot.com K. Chang

    Mr. Thompson, I’d like throw an idea at you…

    What do you think of this… a special class of member/customer that is specifically designed for “internal consumption”, but does NOT generate as much commission as a regular downline?

    Internal consumption is frowned upon by FTC as it blurs the line between “affiliate” and “customer”. Yet DSA wants the internal consumption recognized as perfectly legal. To me, the logical answer is create a hybrid class between customer and affiliate, which I’ll dub… custiliate. :)

    They join a MLM to enjoy buying stuff at the “wholesale” price, so they are customers. They don’t resell or recruit, they are NOT regular affiliates. So, let them join and enjoy the discount ONLY, but reduce the commission for sales to custiliates to perhaps, HALF of a regular downline, or limit them to 2 level payout only instead of normal levels. Or SOME SORT of a penalty for recruiting a custiliate instead of a normal affiliate. (And custiliate CANNOT retail/resell or recruit, though they can convert later).

    MLMs that rely on recruiting people for a ton of self-consumption may balk, but FTC should be happy. What do you think?

    Herbalife lost track of sales as they don’t care about distinguishing between custiliates vs. customers. They only care about sales, no matter the destination. Creating the custiliates class would give all MLMs better visibility.

    • Kevin Thompson

      K. Chang, I think the anti-pyramid bill I proposed is the answer. The issue with reducing PV for personal consumption is two-fold: 1) the companies will NEVER support it. And for this reason, it’s dead on arrival. 2) it’s not fair. If distributors are responsible for volume in the downline, they should be paid accordingly. It’s just as hard to recruit a distributor as it is to make a sale, so the rewards should be the same. Also, there’s a lot of companies that already have “preferred customer” programs whereby customers get access to the wholesale pricing. I think that’s an important step towards improving the issue. The idea that people join as distributors to partake in the discounts is a problem. It’s reality….but it’s also a problem. We need to better separate the business builders from the discount-seekers because this is the data the regulators want to see.

  • http://www.momofactor.com Jonathan Gilliam – Momentum Factor

    Great summary Kevin, well thought out as usual. My only observation is that Einhorm and his ilk, while they sometimes provide a valuable check and balance to corporate reporting, are more often mere opportunists who use their pulpits to yell fire just after they’ve doused a place in gasoline and made off with the furniture. Discovering a “weakness” like personal consumption (an issue resolved years ago) and crushing a good company’s stock for quick profit smacks of manipulation, a practice in which Einhorn has quite a colorful history. And the shorts follow guys like Einhorn like the bottom feeders they are.

    • Kevin Thompson

      Jonathan, Herbalife has historically been in a lot of trouble over this issue. Einhorn never yelled fire. He just reallocated his money and everyone else followed suit. Einhorn never made any public statements about his decision, justifying his action. He just did it and due to his influence, everyone else followed. We all know in the space that a business with a strong customer to distributor ratio is a more stable business. With a publicly traded company, where investors place bets on the sustainability and growth projections of a company, the customer data is very important. Herbalife’s non-answer startled a lot of people and they paid the price.

      We both agree that paying commissions on personal consumption is permissible. The real issue is HOW MUCH personal consumption is too much. Should anyone invest in an MLM that is 100% driven by internal consumption. The answer is an emphatic “no.” I’m really not shocked at Einhorn’s decision. I’m more shocked at Herbalife’s flippant response, basically suggesting that the question was not that important.

      The real bad-boy is the group that shorted USANA. They went to great lengths to argue that USANA was basically illegal, and they misrepresented the law. In my opinion, it was a lie calculated to do harm and yield profit.