The core bear case for Herbalife is that these distributors are deceived - and that there are not huge numbers of real sales - and that the bulk of the sales are to people who are buying it for the business opportunity rather than to consume the product in its own right.
Indeed for this to be a pyramid at law the company needs to be selling the majority of its product to distributors who are not buying this for deliberate personal consumption but rather for the business opportunity.
If the majority of sales are to people who are not active distributors there is simply no way that this is a pyramid. A reasonable summary of the pre-Burn Lounge law from an anti-Herbalife slant is given by Dan McCrum at the FT.
Even he would concede that if a majority of sales were to people who were not active distributors with a valid distribution contract then Herbalife is not a pyramid scheme.
There are several steps to the argument.
Size of Herbalife sales
A large number of people on Wall Street have positions on Herbalife without having thought clearly about its size. It doesn't appear much in their social circles so it must be small.
Bill Ackman (Trades, Portfolio) sneers at them when they say their competitor is McDonalds.
So lets detail it accurately.
Herbalife's main product is Formula 1. It is a protein shake powder used in meal replacement mostly for weight loss. According to the annual filings weight loss products (which are mostly Formula 1 and meal-replacement protein bars) are 63.5 percent of all product. Some of this is diet-suppressing herbal teas - but meal replacements alone are probably 58 percent of all sales - completely led by Formula 1.
Here is an image of several 750 gram packets of Formula 1:
This is the product - above all others - that is associated with Herbalife.
Here is the label which gives a suggested meal-replacement size of 50 grams:
This is a multi-level marketing company. You qualify for various tiers of the distributorship by selling a certain number of volume points in a given time. [For example 4000 or 5000 volume points will qualify you for "supervisor" status depending on how fast you sell them.]
For all Herbalife product the price changes by country - but the number of volume points does not. So whatever country you are in a packet of Formula 1 counts as 23.95 volume points.
During the last quarter Herbalife sold 1.4 billion volume points of product. I have used this slide before showing volume points by region:
1.431 billion volume points would be the equivalent of 59.7 million tins of Formula 1 powder.
Each packet contains 15 fifty gram meal replacements (see the label above). So if it were all meal replacement there would be 896.2 million meals replaced per quarter.
That would be 3584.7 million meals annually.
Not all of this is meal replacement though. My guess [explained above] is that only 58 percent of sales are meal replacement.
That would suggestion 2079.1 million actual meals annually.
Mr Ackman sneers when the company compares itself to McDonalds. But hey - I want to.
We want to compare this to the size of McDonalds. McDonalds serves roughly 70 million meals daily - or 25.5 billion annually.
Here is the comparison: based on number of meals served Herbalife is about 8 percent of the size of McDonalds. [For comparison Herbalife is about 5 percent of the market cap of McDonalds. It does not make sense to compare revenue because McDonalds has a lot of franchise revenue - but it is - for completeness - roughly 18 percent of the revenue of McDonalds.]
These sales numbers are growing by 5 percent annually although that growth rate is slowing.
Herbalife sales per distributor
The number of sales leaders in the company (again according to the above table) is about 340 thousand. To make the numbers work the average sales leader or their down-line is selling 6100 meals per sales leader per year.
If they can get their average customer to consume 200 meals per year [that is replace four meals per week] then they have about 30 regular customers each - and the total number of Herbalife customers is about 10.4 million.
The total number of distributors of Herbalife is 3.7 million many of whom sign up for their own consumption. [The proportion who sign up for their own consumption rather than for the business opportunity is a very big item of contention. Suffice to say that there are a reasonable number of both...]
This number is increased considerably from when Mr Ackman did his original presentation. The 2011 annual report listed 2.7 million independent distributors.
Now here is a big observation: My calculation - there is enough Herbalife sold so that 10 million people globally replace 200 meals a year with Herbalife product.
But there are only 3.7 million people with an active distribution agreement.
We have three choices here. Either:
(a). The sales/revenue numbers cited above are completely fabricated, or
(b). The majority of Herbalife product is consumed by people who are not distributors or
(c). There are massive piles of inventory around not consumed.
I think we can reject hypothesis (a) very easily. The company generates huge amounts of cash and was buying back stock rapidly before Bill Ackman (Trades, Portfolio) came along without blowing the debt out unreasonably. [They have bought even larger amounts more stock since Bill Ackman (Trades, Portfolio) and the net debt has now risen sharply.] They would not have had the cash to buy back stock if the revenue numbers were falsified.
And I think we can reject (c) above pretty easily too. I have spent considerable time looking for the inventory and I can't find it. It is not on Ebay or Craigs list (as per this post). Besides you can now return it for a full refund - so having unsold inventory sitting in the garage is stupid and unlikely.
So we are left with the middle choice - the majority of Herbalife product is consumed by people who are not distributors.
Bluntly: there goes the bear case.
The FTC will - after examining all the documents - come to the same conclusion. And at that point I would not want to be short this company.