Is Herbalife A Scam? Part II

Takeaway: Professor Anne T. Coughlan's weighs in on whether Herbalife is a scam. We also examine the differences between MLMs and pyramid schemes.

Today Hedgeye clients were treated to a private seminar with Professor Anne T. Coughlan, John L. & Helen Kellogg Professor at Northwestern University’s Kellogg School of Management.  A recognized expert in distribution channels, direct marketing and sales force management, Professor Coughlan has received awards for excellence in teaching and is a sought-after consultant in the private sector, where she counts Herbalife among her clients.  She appeared with Hedgeye in her capacity as an independent academic scholar and presented her own views on Multi Level Marketing.


Direct Selling & Multi Level Marketing

Professor Coughlan gave an overview of Direct Selling (DS), with a focus on Multi Level Marketing (MLM).


Direct Selling is well established in the retail marketplace.  Compared with traditional “bricks and mortar” retail, “e-tail,” and franchising, DS offers certain advantages to both the company and the distributor.  DS and MLM also have characteristics that make them look very different from traditional retail models.  But, cautions Professor Coughlan – different does not necessarily mean illegitimate.  Professor Coughlan described the key elements of DS, and of MLM, and contrasted the legitimate MLM structure with Pyramid Schemes.


Distribution Channels

All distribution channels address four basic issues:

  1. The combination of products and services – WHAT do consumers buy?  HOW do they buy it?  Consumers buy a product bundled with delivery services, and sometimes with post-delivery services – think of the expression “shopping experience.”
  2. The structure of the distribution channel – WHO is in the channel?  HOW are functions allocated?  WHO does the work at each step? 
  3. Compensation – HOW are people compensated? WHAT are the incentives driving added-value activities in the channel?
  4. Governance – HOW is the program implemented and overseen?  WHAT are the rules of conduct, rules for resolving conflicts and for protecting both customers and participants?  HOW are channel participants’ investment protected, while ensuring end users access to a quality product?


The MLM Company

The MLM company develops the product and performs R&D and market research.  The company administers the business: it sources product, performs quality control, and handles logistics to ensure inventory and delivery. In addition, the legitimate MLM company makes a significant investment in technology and administrative staff to effectively manage payment of compensation and incentive awards to its distributors.


The key characteristics of a legitimate MLM company include: actual product which is differentiated, usually by premium quality or scarcity.  Legitimate MLM companies make their money from selling product, not from recruiting fees; they discourage distributors from taking on large inventories, and generally allow departing distributors to sell unused product back to the company.


Advantages of the MLM Model

Individuals are attracted to MLM selling for a number of reasons.  Becoming an MLM distributor offers an aspiring businessperson an opportunity to try out their skills without incurring the cost and liability of setting up a business.   

Distributors set their own goals and success is measured by individual satisfaction, not corporate guidelines.  One reason revenues look very different among MLM distributors from the profile at a traditional retailer is that most distributors are satisfied if they can defray the cost of their own consumption of the product.  Also, many people push their sales efforts seasonally – to pay for Christmas shopping, tuition or summer camp.  


People become MLM distributors because they love the product, not to become financially successful.  This is the biggest reason for low profitability in distribution downlines.  Most distributors are satisfied with small profits and continued access to the product for their own use.  Horror stories of housewives stuck with a garage full of shampoo and deodorant do not describe the operation of a legitimate MLM company.


Companies value star salespeople, and star MLM distributors are incentivized in a fully transparent fashion.  Those few distributors who can successfully develop large downlines are the key to continued sales growth.  While outsiders may think these business leaders are getting paid “off the backs” of their downline, they work very hard mentoring and training to ensure the success of their downline distributors, adding real value to the company.  It is a rare combination to be a great salesperson AND a great recruiter AND a great trainer AND a great motivator AND a great mentor.  Sales pros who can deliver on all these front are well rewarded.


A legitimate MLM company offers the same compensation structure to every distributor, and the compensation is clearly laid out, including incentive awards and the requirements for attaining them.  Anyone can become a star.  The fact that most people do not is attributable to human nature, not to a flaw in the business model.  “The flaw,” laments Cassius to Brutus, “is not in our stars but in ourselves.”  


So What is a Pyramid Scheme?

The primary characteristic of an illegitimate pyramid scheme is that people are paid to recruit others into the pyramid.  Rather than derive revenues from the sale of product, pyramid schemes charge a registration fee, usually non-refundable.  Many pyramid schemes do not even deliver an actual product, just an “opportunity.” 


The first red flag is the compensation clause that says you get paid to recruit new distributors, even if they never sell anything.


Other red flags include a requirement to purchase large quantities of inventory, or requiring standing orders to be filled automatically, and which can not be returned if not sold.  A pyramid scheme will not make a meaningful investment a product or an organizational structure.  


How Do You Tell The Difference?

If distributors continue to use the product themselves, even if they are not making money off their own sales, Professor Coughlan says that is a strong indication a company is a legitimate MLM organization, and not a pyramid scheme.  Remember that people get involved in MLM sales for a variety of reasons, and “value” is defined very differently in MLM than in structured sales organizations.  If the company maintains R&D spending, it is a strong indicator that this is a legitimate MLM operation.  The fact of individuals being more or less financially successful should not be seen as the determining factor, says Professor Coughlan.


Bottom Line: What About Herbalife?

We remind you that Professor Coughlan works as a paid consultant to Herbalife from time to time.  Nonetheless, she was able to speak clearly about publicly available information, comparing it with financial information from similar public companies.


Professor Coughlan says, based on their public reporting, HLF’s compensation, production and distribution practices are comparable to industry norms, as are their interactions with distributors and end users.  HLF does not charge high enrollment fees, and fees are refundable if distributors opt out within 90 days.  HLF makes an ongoing investment in product design and buys back unsold inventory when distributors depart.  The company discourages “inventory loading,” where distributors take on large quantities of inventory they may not be able to sell.  HLF cites its own research showing “a lot” of end use by actual customers, i.e. buyers outside of the distribution downline. 



Professor Coughlan says, based on publicly available information, HLF is comparable to other accepted MLM companies.  The company’s compensation structure is “in the same ballpark” as other recognized companies, and the details of the compensation structure are well publicized across the distributor network.  


Like other DS organizations, HLF’s distributors are the company’s own best advertisement, and it plows excess revenues back into compensation.  Professor Coughlan says HLF’s total compensation is roughly equivalent as a percentage of revenues to the combined sales and advertising budget of major personal care companies with traditional sales forces made up of employees.


For a company that doesn’t advertise, HLF has gotten an awful lot of publicity lately – not all of it good.  Professor Coughlan’s analysis provides a valuable framework for assessing the outlook for this company.  The jury is still out, but it has just gotten an important new piece of evidence.


Watch our website for updates as Consumer Staples sector head Rob Campagnino continues to monitor developments at Herbalife.



History suggests CCL could underperform over the next month


  • The chart below shows the stock’s performance following the Carnival Splendor fire on 11/8/2010 as a comparison to the current Carnival Triumph fire. 
  • CCL underperformed for 3 weeks and it took the stock a month and a half to recover its losses vis a vis the S&P 500.  However, the stock did recover, although some of that was earnings related.
  • The publicity is much worse this time.   Normally, we would buy the negativity but this kind of hype is likely to affect bookings for a period of time – potentially more damaging during the busy wave season - that could lengthen the stock’s recovery period.



Labor Market: Tailwinds Morphing?

This week’s initial jobless claims number was positively impacted by snow in Illinois and the New York/Connecticut area as claims fell 25k to 341k from 366k week-over-week. Keep in mind that while the labor market is undergoing a positive transformation of sorts, the end of the seasonal adjustment tailwind will end at the beginning of March. Nothing dramatic will take effect immediately, but over time, a slow headwind will build that will peak in August as the cycle begins again.



Labor Market: Tailwinds Morphing? - 1 normal



Another important note is that the rate of improvement in the labor market is slowing. The 4-week rolling average of non-seasonally adjusted claims, which we consider a more accurate representation of the underlying labor market trend, was -3.0% lower year-over-year, which is a sequential improvement versus the previous week's year-over-year change of -0.7%. Bigger picture, the labor and housing markets are continuing to improve providing an ongoing tailwind for deep-value, high beta names within the sector.


Labor Market: Tailwinds Morphing? - 2 normal


Labor Market: Tailwinds Morphing? - 3 normal

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Broken France?

We’ve long had a skeptical eye on Socialist President François Hollande since he entered the stage in May 2012, beginning with his very loud “tax the rich” campaign slogan and lack of focus on reducing France's fiscal fat.  With fears now decidedly marginalized on the dissolution of the Eurozone; no imminent threat of a sovereign needing a bailout; and Draghi’s OMT bazooka still calming markets, we return to France, the region’s second largest economy, for a closer look at the risks we see developing that may be overlooked. 


What’s mattered greatly to many investors at the country level since the “crisis” began is countries meeting or exceeding their growth targets and reducing their debt and deficit levels.  France, not unlike what we’ve seen from peripheral countries since 2009, looks to miss its 2013 GDP and deficit targets.   In recent days President Hollande has hinted at a willingness to change the growth forecast from +0.8% to +0.3%-0.4%, however has not backed off the deficit target of 3% of GDP. We think a revision to both is a question of when, not if.


Interestingly, the sticking point on when this change in forecast could result may have to do directly with the timing of a European Commission’s economic report on the Eurozone. It is expected to come out in late February and show that French growth should be in the +0.3%-0.4% range and that France is projected to undershoot its deficit reduction target. A recent state audit should also influence Hollande – it revealed that in a scenario of +0.3% growth, inline with current IMF projections, the deficit would be 25bps over the target, or 3.25%, and added that the state has relied too much on tax increases and needs to focus on spending cuts to attain its targets.



Beyond the Deficit Are Storm Clouds


While a miss of its deficit target may not cripple confidence in France, it adds to a perfect storm of negative trending risks, which include:

  • Public debt – pushing 91% (as a % of GDP) - France is above the level of 90% that economists Reinhart and Rogoff have indicated as destructive to growth.
  • Credit Rating – Fitch is the only main agency to maintain its AAA status. S&P is at AA and Moody’s at Aa1. We expect all three to be lined up at AA in 2013 and for this reduction in credit standing to weigh on its public finances, and put upward pressure on yields.  Note: The 10YR is currently trading at 2.26% (versus 1.64% in Germany), and has remained stubbornly low over the intermediate term despite the risk premiums we see, a development that we believe has a high probability of inflecting in 2013.
  • Competitiveness Drag – Hollande’s policy to tax the rich (75% on those making €1MM or more) is not only driving out his countrymen but sending negative investment signals to the business community. Hollande has moved the top rate of capital gains tax from 34.5% to 62.2%. For reference these levels compare with 21% in Spain, 26.4% in Germany and 28% in Britain.
  • Hamstrung Spending – we believe that Hollande will not be able to issue additional spending cuts due to push back on the street against austerity. Politically, Hollande also doesn’t have the popular support to make an estimated €5B in additional cuts to attain the deficit target.
  • Bank Leverage – French banks remain an outside concern due to their leverage to the periphery. While we expect Draghi and Co. to keep the union together at all costs, the weight of a still imbalanced financial sector could sway sovereign sentiment.


Economic Misses

Today Eurostat reported initial GDP figures for Q4 2012.  France’s Q4 GDP came in at -0.3% Q/Q versus expectations of -0.2% and +0.1% in Q3. While France outperformed the Eurozone aggregate of -0.6% Q/Q (versus expectations of -0.4%), the high frequency data that we track continues to paint a negative trend for France, one that inflects versus the larger peer economies of Germany and the UK. 


France’s PMI Services number for JAN was 43.6 JAN vs 45.2 in DEC and Manufacturing fell to 42.9 in JAN vs 44.6 in DEC, both decidedly under the 50 line representing contraction.


Broken France? - 33. gdp


Broken France? - 33. pmis


Further, the policy measures that Hollande has implemented are showing up in confidence readings. Business Confidence has rolled down the mountain since a high in March 2012, Consumer Confidence has been flat to down since Hollande’s election, and Consumer Spending has been under 1% since mid 2011 and negative for the last 5 consecutive months. 


Broken France? - 33. business conf


Broken France? - 33. consumer spending



Given France debt drag, likely misses on 2013 GDP and deficit reduction, and financial and economic constrains, the country is one to watch given the downside risks. From a capital markets perspective the country has been surprisingly resilient, but this could well change.  While the wave of sentiment may be more focused on the governments of Italy and Spain currently, we caution that the risks in France could drive a stagflationary set-up in the country for much longer than is currently being priced in.  We think the Hollande’s political handcuffs will prevent necessary spending cuts and his decidedly anti-business tax policy will chase good money out of the country.  Stay tuned.   


Broken France? - 33. indust and manu product



Matthew Hedrick

Senior Analyst

BLMN: Conflict On Wall Street

This note was originally published February 13, 2013 at 15:02 in Restaurants

Bloomin’ Brands shares could be a good short at this price. 





Sell-side ratings on Bloomin’ Brands shares indicate a strong, bullish bias with 73% of analysts recommending buying the shares.  With casual dining sales trends deteriorating, we believe BLMN is a good candidate for investors looking for short ideas as earnings expectations are unlikely to rise from here.


The consensus Price Target, illustrated in the chart below, is below the price of the shares and we do not expect sentiment to rise much further.  Both the multiple (>1.5 turns above casual dining average) and the earnings estimate are not likely to have much upside. 


BLMN: Conflict On Wall Street - blmn target price



Private Equity Profit-Taking


Given that 66% of the company, or $2.5 billion in stock, is owned by private equity firms, it is unlikely that there will be a sea-change in sell-side ratings any time soon.  However, we would think that a private equity firm considering current sales trends would be glad to offload shares at $18, or 9.3x cash flow.


BLMN: Conflict On Wall Street - blmn valuation comp




Takeaway: Japan’s bleak cyclical data remains the perfect handoff to the structural policy changes outlined in our bearish thesis on the yen.



  • Do your best to drown out the rhetorical noise coming from the G20 Summit and stay short the yen, which is now down -16.6% vs. the USD since we outlined our bearish bias back on SEP 27.
  • With major policy catalysts hanging in the balance, there is a lot more downside from here in our perspective, despite the trade having now become consensus – particularly among noteworthy Global Macro investors (see: FT article titled, “Hedge Funds Reap Billions on Yen Bets”).


MAJOR DEVELOPMENTS: On Tuesday, we published a note titled CURRENCY WAR UPDATE: THE G7 BOWS TO JAPAN; to the extent you may have missed it come through, please review that as a preamble to the brief prose below.


  • GDP bomb = recession continues: Japan’s 4Q Real GDP figures were released overnight and they left much to be desired in the way of healthy economic growth: +0.3% YoY from +0.4% prior; -0.1% QoQ from -1% prior vs. +0.1% Bloomberg consensus estimate; -0.4% QoQ SAAR from -3.8% prior vs. +0.4% Bloomberg consensus estimate. This confirms our call for Japan’s recession to extend into a third-straight quarter.
  • Things are picking up, though?: The conclusion of the BOJ’s latest two-day policy meeting produced little in the way of critical policy developments. The ¥76T Asset Purchase Program, ¥25T Bank Credit Program and ¥1.8T of monthly JGB purchases were all left on hold – as was the 0.1% Call Money Rate. What did qualify as news was board upping its view of the Japanese economy to “… appears to have stopped weakening” from “… remains relatively weak” at the prior meeting. This delta is more influenced by the timing of recent fiscal stimulus spending and improved consumer and business confidence figures than actual economic growth indicators – which remained very subdued in JAN-to-date.
  • Shirakawa’s last ride: The next BOJ meeting on MAR 7 will be the final meeting presided over by Governor Masaaki Shirakawa’s and his two deputy governors Hirohide Yamaguchi and Kiyohiko Nishimura. In rejecting Ryuzo Miyao’s call for a pledge of ZIRP until the inflation target is “in sight”, the three amigos signaled they want to ride off into the sunset much like former ECB President Jean-Claude Trichet – appearing uncompromised, unwavering towards market or political demands.
  • The next guys and gals won’t be so lucky:Much like Mario Draghi has become with respect to European banksters and financial market participants, we continue to believe their replacements will become more-or-less puppets of the Abe administration’s broader political agenda for the Japanese economy – which is +5% “monetary math” (+3% nominal growth and +2% inflation). From an intermediate-term TREND and long-term TAIL perspective, we expect whomever is running the BOJ to do “whatever it takes” to meet the aforementioned targets.
  • Minor hiccups may remain though: One very minor hurdle on the track to ‘USD/JPY = ¥100’ is Your Party’s recent pre-rejection of Haruhiko Kuroda and Toshiro Muto as candidates to be the next head of the BOJ because they are ex-MOF officials. That leaves only former BOJ Deputy Governor Kazumasa Iwata as the only consensus candidate remaining that stands to make it past the Upper House vote where the LDP does not have a majority. Dare we say a dark horse currency debaucher will emerge as the next BOJ head?
  • G20 Summit = all eyes on the yen: Another potential hurdle is this weekend’s G20 Summit. If, however, the G7 statement issued earlier this week is any indication of this weekend’s pending takeaways, we continue to anticipate muted international resistance to Japan’s Policies to Inflate. For now, it appears no country is fully prepared to officially stand in the way of the Japanese Cabinet Office’s political objectives. Japan’s awful 4Q GDP miss supports this conclusion in that it likely buys Japan more international goodwill/scope to carry on debauching.
  • Where to from here?: Do your best to drown out the rhetorical noise coming from the G20 Summit and stay short the yen, which is now down -16.6% vs. the USD since we outlined our bearish bias back on SEP 27. With major policy catalysts hanging in the balance, there is a lot more downside from here in our perspective, despite the trade having now become consensus – particularly among noteworthy Global Macro investors (see: FT article titled, “Hedge Funds Reap Billions on Yen Bets”).


Darius Dale

Senior Analyst










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