Months before the recent Sturm und Drang surrounding nutritional-supplement maker Herbalife, my firm took a long, hard look at the company. On the surface it was a value investor’s dream: great balance sheet, high return on capital, high revenue and earnings growth, and attractive valuation. Of course, there was one problem: The validity of its multilevel marketing (MLM) pyramid structure was being questioned by some investors.
To my surprise, despite its name, there is little that is “herbal” about Herbalife.I thought I’d see a lot of exotic plants reincarnated as wonder miracle supplements. What I discovered is that the majority of Herbalife’s sales come from its Formula 1 product, a meal-replacement supplement. If Herbalife’s products were sold at Walgreens or GNC, the story would be very simple, but it is not. The company’s business model is in question because investors suspect that its products are bought just as “trading sardines” (they might as well be bricks or wooden sticks). If at the end of the day its supplements are not consumed but instead rest peacefully in the garages of its distributors, Herbalife is nothing but a Ponzi-like scheme that will run its course — they always do.
Whether they are long or short Herbalife shares, investors have to have a clear answer to one question: Is Herbalife a Ponzi-like scheme? In our research, finding a definitive answer was very difficult. Herbalife is not unlike a typical MLM company that spends most of its time painting a picture of a Ferrari-embellished financial freedom that awaits you just around the corner if you sign up enough distributors to sell its products.
Herbalife claims that the bulk of its supplements are consumed on a daily basis at “clubs,” of which there are thousands around the world. Clubs are owned and operated by Herbalife distributors and are supposed to be social spots for Herbalife connoisseurs to meet, share their weight-loss war stories and, for about $6, down a shot of Formula 1 and swig some aloe vera juice.