Click here For Part I.

The company has been fairly clear why it is like that. The explanation is that for a MLM it is important for distributors to protect the second sale.

Avon (famously) opened stores (under Andrea Jung as CEO) and it was a disaster. The issue is that if a woman knocking on doors gets a woman to buy Avon she will likely get a further sale out of it later. Indeed the job of an Avon lady is to build up a book of repeat customers - and the job of a Herbalife distributor is similarly to build up a book of repeat customers.

Alas if the customer can buy it from a store that undermines the direct selling model. [You can't get a second sale if the customer can easily go elsewhere.]

To protect the business of their distributors the company prohibits anyone from opening a store that is identifiable as a Herbalife store (except to people in enough know to recognise the colours), or to sell it online (which is why the Ebay people I have approached are evasive).

That said - the store rules have been a source of short-conspiracy thesis ever since. The rules are clearly to protect the business of existing distributors but if you do not understand the underlying business rationalle the rules look perverse. The company has - in my observation - made consistent moves entirely to protect the business of existing distributors – and many seemingly perverse company moves can be understood only in that context.

Bill Ackman (Trades, Portfolio)’s later presentations

Bill Ackman (Trades, Portfolio) has followed up his original presentations with several more.

One is a documentary interviewing several Herbalife victims. It turns out that every victim was a victim of Shawn Dahl and the money they lost substantially went to Shawn Dahl rather than to Herbalife. Shawn Dahl's downline was (at most) a low single-digit percentage of Herbalife.

Another is a study arguing Herbalife’s (fast growing) business in China is illegal under Chinese law.

This is an area where I feel quite qualified to comment. In China I visited three Herbalife distributors, two in Beijing without permission from the company and without giving the company advance notice and one in Dongguan with guidance from the company. I travelled with a translator quite expert in the relevant Chinese rules (the translator had previously spent some time sceptically researching Nu Skin's rather dodgy China operations). [My China notes are below.]

Full refunds and the change in short-thesis from “it's a pyramid in fact” to “it's a pyramid at law”

The response to the original short-thesis was to (a) ban lead-sellers as discussed, and (b) implement the “gold standard” for refunds which offers a full 100 percent refundincluding postagefor all sellers on unopened product and for opened starter kits. The refund rules are in the top of all boxes sold by Herbalife and in the US are sent in English and Spanish.

This was to prove that inventory loading did not happen and it could not be a pyramid in the sense originally described by Bill Ackman (Trades, Portfolio).

There have been some quibbles about this refund. It does not include postage paid by the customer in receiving the product and several people have tried to argue that this is a major profit centre for the company. [This postage is not paid in a large proportion of non-American-non-Chinese sales - as these are field sales - discussed below.] However you count it though the refund is more generous than required under the Amway safe-harbour provision - and the evidence is that it is honoured scrupulously on the ground.

As a result there was a change in the short-thesis from it's a pyramid in fact(proven by inventory loading and having to recruit more victims to buy more inventory) to it's apyramid at lawbecause all the customers are insiders - that is members of the club - and that all sales are to people who are legally signed up as distributors.

In other words Bill Ackman (Trades, Portfolio) retreated to David Einhorn (Trades, Portfolio)’s original (and poisonous) questions.

The company has always denied that a majority of sales are to people who have signed up as a distributor but (until very recently) they did not give definitive data and even that data came from a commissioned survey and not from their own distributors. As stated compliance with distributor rules about how the distributors should report sales to external customers is thin (in part because many of the distributors are illiterate).

The company press release that gave the critical data out is here:

http://ir.herbalife.com/releasedetail.cfm?ReleaseID=861186

The release is several years late and vague - and as stated the source of the data was Herbalife-sponsored surveys of its U.S. customers and Members that were undertaken by the market research firms Lieberman Research Worldwide and The Nielsen Company, B.V.This looked rather thin and the fact they needed to rely on third-party research data rather than their own extensive (Oracle) based system tells you that compliance by their distributors is far from total. [In visiting various distributors I can assure you I have seen the full-range from utter compliance to total disregard of the 70 percent rule.]

Whatever, the 70 percent rule now looks like it is unnecessary because the BurnLounge case made it clear that the question was really whether the purchases are not merely incidental to the business opportunity.

How big is Herbalife by sales - and comparisons to numbers of members

When Herbalife quotes its quarterly numbers it quotes them in dollars and also in “volume points”. Volume points are how status (hence commission) in the Herbalife structure is determined. All products (except the business starter kit) have a certain number of volume points attached and that number is independent of the price of the product or which country it is sold in. [The business starter kit has no volume points attached because payment to the upline for selling business starter kits would clearly be a “recruiting reward” as per the above-mentioned Koscot case.]

A tin of Formula 1 is the same number of “volume points” in every country in the world.

I did the calculation in the second quarter of 2014. Volume points have shrunk somewhat since then (and I will explain why below). But this gives a reasonable scale for the business.

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Global volume points were 1.43 billion for the quarter. This is the highest rate ever - but annualizes at 5.72 billion.

32 percent of sales are Formula 1 [a number that comes from the Bill Ackman (Trades, Portfolio) slide above].

This suggests that annual Formula 1 sales are 1.83 billion volume points (annualised).

These are 750 gram tins of Formula 1 [the tin comes in two sizes - the other being 550 grams].

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The tins represent 32.75 volume points (as per this linked brochure).

The suggested meal (and the ones that I have been served in clubs) is a 25 gram scoop of Formula 1 blended with skim milk. [If you do not want to use milk use more Formula 1 but taste is compromised.]

This suggests that a tin contains 30 “meals” or enough for a month. [This is consistent with Herbalife user blogs…]

It is not quite a meal equals a volume point - but a meal is 1.08 volume points.

That suggests that annualFormula 1 meals sold is about 1.7 billion or 4.6 million per day.

That is an astounding number. McDonalds famously serves about 70 million meals per day - so it is 6.6% the size of McDonalds in terms of meals served. Moreover there are 3.7 million distributors but only 340 thousand sales leaders.

If ALL the distributors had one meal per day every day of the yearthen you still would not account for volume.

Moreover many distributors are lapsed or have very low volumes. So in order for it to be majority sold to Herbalife distributors [and hence be a “pyramid at law” there have to be a vast number of distributors who consume multiple meals per day of Herbalife. Alternatively they must have enormous stockpiles in their garages.]

Distributors who allegedly consume multiple meals a day

The calculation I make above – showing that to be a pyramid most the distributors need to consume multiple meals a day has – to some extent – become the short case.

Indeed, this is what Bill Ackman (Trades, Portfolio) alleged in one of his later presentations that focuses on “Club 100”. I think implausibly the short-selling crowd came up with the idea that the distributors were consuming seven plus meals per day.

Club 100 - an introduction

There is a kind of nice (and rather glitzy) video about clubs put out by the company - and it turns out that about half the clubs are Club 100 members [visible in logos on the wall and the like]. Club 100 is clearly a big thing.

https://www.youtube.com/watch?v=sPkruX-fMb4

They also have training programs, and it is through the training programs that shorts have alleged that people eat up to seven Herbalife meals a day for reasons entirely concerned with the business opportunity. These training programs have become the means by which shorts think Herbalife fails on the test defined in the Burn Lounge case.

I am not making this up.

You need only look at a SeekingAlpha article by Christine Richards. Christine Richards is a former journalist who worked for a hedge-fund-research shop called The Indago Group. She is also the hagiographer of Bill Ackman (Trades, Portfolio) (I think it was a paid biography). Richards has since left the Indago to start her own firm (Orion Research). By repute (though it may not be true) it was her who planted the Einhorn questions.

Here is the Christine Richard article(which had a surprisingly negative effect on the stock). I quote it nearly in full because it is the entirety of Bill Ackman (Trades, Portfolio)’s new thesis (and the now 650 comments on the article tell you the ardour at with which all this stuff is debated):

Herbalife: Who's Consuming All Those Shakes? And Why...

Summary

• On the ground investigative research into Herbalife's nutrition clubs suggests they're not what they seem.
• Club 100's quota system raises questions about the true nature of shake consumption.
• The motivation for sales in an MLM matters per recent rulings; that could be a factor in considering Herbalife's business.

What's the truth behind Herbalife's Nutrition Club business? If you read thisrecent Reuters article, based on interviews the reporters did with people they encountered at ten Nutrition Clubs, you probably came away believing these Clubs are a force for good in the Hispanic community. I think the reporters were deceived by what they saw and heard, and I base this statement on several years of researching these Clubs, not just in the U.S. and Puerto Rico, but Mexico, Colombia, Venezuela and Brazil. Walk into an Herbalife Nutrition Club and you enter into a charade created by an elaborate and cynical "training" system that turns distributors and their family members and friends into conscripted consumers. Let me explain how I came to that conclusion.

I started visiting Herbalife Nutrition Clubs in 2011 as part of a project on behalf of a number of hedge fund managers who were trying to determine whether Herbalife Ltd. (NYSE:HLF) was a legitimate business or, as some critics alleged, a pyramid scheme: an unsustainable and illegal business model in which participants make money primarily by enrolling new participants in the business.

To help answer this question, I decided to take a close look at Herbalife's Nutrition Club network, which was (and still is) fueling the company's growth. These Clubs, which serve single portions of the company's products such as its Formula One protein shake, were popular with a surprising demographic in the U.S.: Hispanic immigrants in low-income neighborhoods.

I started my research by visiting the Corona neighborhood of Queens, mapping out the Clubs surrounding Junction Boulevard and Roosevelt Avenue. Many were hidden away in undesirable retail locations, down alleys and in the basement level of strip malls, with shabby looking storefronts and interiors hidden by green curtains. A handful, however, were more prominent and had signs (in Spanish) that expressed boundless optimism: "A Beautiful Life," "A Better World," etc. But one thing I knew for sure was that there were far too many of these Clubs to make any economic sense: I found 26 within a few blocks of the Junction Boulevard subway stop.

Shortly after, I started visiting Nutrition Clubs with hedge fund clients. Herbalife was under no particular scrutiny then, which was a good thing, because we certainly didn't blend in at the largely Ecuadorean-run Clubs we were visiting: a middle-aged white woman, with a notebook and a printed Google map of the neighborhood, and a hedge fund analyst, invariably "dressed down" in baseball cap and extraordinarily expensive loafers. [John's note: baseball cap and loafers sounds very like David Einhorn (Trades, Portfolio).] We stood out like two Jehovah's Witnesses canvassing the neighborhood - and that was before we opened our mouths. On one of my first visits with an analyst, I warned him that my high school Spanish was a bit rusty and asked if he spoke any. Alas, he replied that he had studied Latin in school.

During our visits, we identified ourselves as analysts seeking to better understand the operations of this publicly traded company. I think most people suspected we were from Herbalife's compliance department, checking to see whether they were following the company's endless and often bizarre rules: no Herbalife signs visible from the street, all doors and windows covered to prevent visibility into the Club, no "Open" or "Closed" signs, no selling full containers of products, etc. (These rules alone raised serious doubts in my mind about how a distributor could hope to succeed.)

The people we met in the Clubs were without exception friendly and tolerant of the communication barrier. They believed Herbalife was transforming their lives from paid-under-the-table kitchen help and construction workers into full-fledged achievers of the American Dream. They talked about Nutrition Clubs as a route to the prestigious and lucrative Herbalife "President's Team." I left every Club I visited hoping that somehow this business would work out for them.

Many people dismiss the harm done by pyramid schemes, downplaying it with comparisons to companies that sell us things that aren't very good for us: cigarettes and liquor, fast food and lottery tickets, etc. But this is a spurious comparison. Nobody who smokes thinks it's good for them and nobody who buys a lottery ticket thinks the odds are in their favor.

Meanwhile, deceptive business opportunities reshape lives around lies, making deep inroads into a person's psyche, changing whom they interact with and whom they shut out, how they spend their waking hours, and how they dream about and build for their future. Robert Fitzpatrick, an expert in analyzing business opportunity fraud, had concluded that Herbalife's business was based on deception long before I began my research. He summed it up in an email he sent me: "Herbalife has entered the fabric of Main Street. It has tampered with the souls of millions of people."

So, what was Herbalife doing with these souls in this hardworking, immigrant community in Queens? Was it delivering on its promise of a better life for the people who attended and ran these Clubs? If so, there was something extraordinary at work here: a company that had found a way to engage those at the bottom of the economic ladder, people confronted with daily hardships most Americans can only imagine, and through its products and business opportunity was steering them toward better health and financial security.

For some, Herbalife clearly hadn't delivered on this promise, as evidenced by the dozens of shuttered or moribund Nutrition Clubs I saw, testaments to someone's failed dream - and to my suspicion that these Clubs were a place for disillusioned (and broke) Herbalife distributors to dump the product they'd been forced to buy in their pursuit of the "business opportunity."

But I also found active Clubs and watched as people came through the door, handed over $5, and drank servings of the products. I watched Club operators record each person's name and proudly explain that these customers came each and every day - they were frequently described as "socios" (the Spanish word for partner) in this grand Herbalife vision of health and financial freedom. Yet, there was always a hint of staging to these interactions. More than once I asked a person visiting a Club if he or she worked there or was an Herbalife distributor, and the answer, from a person with a limited English vocabulary, was jarring: "No. I just come here to consume." Consume?

One morning I visited a number of Clubs with a well-known hedge fund manager -- a positive sign that interest in our research was trickling upward. Hedge fund types tend to be health and body conscious and while most were curious to see the products, they baulked at actually consuming them. "You can never be too careful about what you put into your body." This meant that when the host's back was turned, I frequently switched the cups and ended up drinking both servings. But, on this day, my companion was 100% into the research; he gamely consumed at every club and complimented the host on the preparation. Among the Clubs we visited was one enthusiastically staffed by a husband and wife team, who phoned their high school-age son to come and translate. All three were distributors and had put the family savings, plus money borrowed from relatives, into the Club.

On our final stop, we climbed a creaky flight of stairs to the second floor where -- expecting to find a locked door or a deserted Club -- we entered a tiny room in which about a dozen men in bulky hoodies and heavy work boots sat silently on folding chairs, eyes fixed straight ahead, Formula One shakes in hand. These men were vaguely familiar, the faces one glimpses hauling debris out of buildings undergoing renovations, bussing dishes in the kitchens of restaurants, and flying through treacherous Manhattan traffic on rickety bicycles, delivering food. They certainly weren't overweight and didn't appear to have the luxury of the time or money required to consume expensive nutritional shakes in a Club. But nevertheless, here they were, doing what Herbalife claimed so many in the Hispanic community loved to do: gather in a social setting to enjoy good nutrition.

The host had a bright - though slightly bemused - smile for us. Everyone else could have been waiting for a bus; oblivious to a cartoon blasting in Spanish on an overhead TV, the men ignored one another and avoided eye contact with us.

With every seat taken, we had to stand, drinking our third Formula One shake, Aloe Water and Herbal Tea of the morning, a good 40 to 50 fluid ounces each into our research. A few minutes later, in search of the bathroom, we were directed into a large adjoining room where, the host explained, the group held regular training meetings. It was empty, lights out, but he assured us that it filled up twice a week with all of the distributors in the neighborhood who were learning the business.

On our way back down the stairs, I asked my companion if he thought people were really there because they wanted to drink a Formula One shake.

"No."

So what were they doing?

Herbalife claims that Nutrition Club visitors are genuine customers seeking better health and are drawn to the Clubs because they lack the economic resources to buy an entire container of Formula One, so instead they're paying a few dollars a day to consume single portions of the products. These consumers prove that Herbalife is not a pyramid scheme, according to the company, because, after all, if the sales in Nutrition Clubs are to real customers, then the commissions Herbalife pays on the purchase of those products to the distributors operating the Clubs are linked primarily to retail sales, not to recruitment and qualification.

Were these men grudgingly consuming shakes in a tiny Club in Queens examples of the customers that proved Herbalife was not a pyramid scheme?

The answer only became clear later, when I was hired full-time to study Herbalife by another hedge fund manager, Bill Ackman (Trades, Portfolio), whom I met as a reporter covering his short position on a bond insurance company called MBIA. That was a seven-year story, and you can read a book about it here. MBIA, which insured bonds backed by risky mortgages and magically turned them into triple-A-rated securities in the run-up to the 2008 credit crisis, was a company that, like Herbalife, one might argue was in the too-good-to-be-true business.

Soon after I began work for Ackman, I came across the first "Club 100" Nutrition Club on the Internet. The group, also known by its Spanish name "Club Cien," appeared to make up a vast network of Herbalife Nutrition Clubs in the Hispanic community in the U.S. and across Latin America. I found a Yahoo message board used by Club 100 members in Venezuela describing the rules for visiting an Herbalife Nutrition Club.

Rules for customers?

I ran parts of the text through Google Translate and out spilled a cryptic and clunky description of how a person visiting a Club is supposed to act:

"AVOID MAJOR GROUPS OF 5 PEOPLE BY CLUB TO VISIT."

"AVOID THE USE OF UNAUTHORIZED PHOTO CAMERAS."

"AVOID TALKING TO CONSUMERS CLUB, UNLESS YOU ASK THE HOST."

"CAN BE VIEWED ONLY CLUBS THAT ARE 25 AND MORE ACTIVE IN THE SYSTEM CERTIFICATION WITH SEALS."

"REMEMBER THE RULE: ALWAYS GOOD ATTITUDE: SILENT, KIND, ASSIGN CONSUMERS CHAIRS. IF TESTIMONY TO HELP AND GIVE WHAT YOU ASK, SEEK TO AVOID SPECIFIC PRODUCTS OR FLAVORS , WITH QUESTIONS TO AVOID HOST STOP OR WHILE STUDENTS ARE RESPONDING TO CONSUMERS."

It was stunning.

Since when are real customers told to remain silent and instructed not to ask for certain flavors? But, if the people visiting Nutrition Clubs weren't real customers, who were they?

To find out, we hired freelance reporters and private investigators to visit Club 100 Clubs in major cities in the U.S. and Puerto Rico, then in Mexico, Colombia, Venezuela and Brazil. There was a great deal of secrecy surrounding Club 100's business methods. We were often told that only those who signed up with Herbalife through Club 100 were allowed to know how the plan operated. Even those already enrolled in the group were kept in the dark about much of its operation and were told they would be informed about the next phase only after completing the current phase. We signed up and joined Club 100 agreeing to do exactly what we were told was necessary to succeed. Our investigators uncovered a business that turns those seeking to open Nutrition Clubs - along with family members and friends helping them pursue their dream - into conscripted consumers by forcing aspiring Club owners through a series of tasks: touring Clubs and paying to consume at each one, working for free in an upline distributor's Club while being required to consume on the job, and practicing making hundreds of shakes, which family members are required to buy and consume. Trainees also are required to create a story or testimonial about the benefits of the products on their health and to tell this story numerous times to potential recruits in order to graduate. Only those who complete all these tasks, which are tracked and verified by upline distributors on an official form, are certified to open their own Clubs.

The promised rewards are enticing. Those who follow Club 100's rules are told they will reach the President's Team where they can expect to earn hundreds of thousands of dollars a year for the rest of their lives. Herbalife's own data suggests that fewer than 1-in-10,000 distributors will reach the President's Team - but these nearly impossible odds are rarely if ever disclosed to recruits.

Instead, Herbalife trainers (i.e. recruiters) play on desperation and disappointment. In the U.S. we recorded training sessions where messages like the following were directed at undocumented workers for whom the American Dream had proved elusive:

"If you take it (the certification course), you'll get good consequences. If you leave it, I don't know how life will go for you, because how long have you been in this country? 10? 15? 20 years? Another 5, 10 or 20 years will go by and you'll continue in the same spot. Because if in another 5 or 10 years you haven't achieved what you expected in this country, you're not going to achieve it."

On July 22, 2014, as part of Bill Ackman (Trades, Portfolio)'s presentation on Herbalife entitled "The Big Lie," I detailed our findings about Club 100. While investors appear to have mostly ignored our findings - on the company's second quarter earnings conference call a few days later, not a single analyst asked about Club 100 - I believe it is key to understanding the character of Herbalife's business, and, ultimately to forecasting the company's fate.

Herbalife aggressively sells its "business opportunity" - but requires lots of coerced consuming to access it. Our team's months of research in the U.S., Puerto Rico, Mexico, Colombia and Venezuela showed that a distributor diligently attempting the certification process - the first step in Club 100's complex and secretive plan - would consume or cause other people to consume about 632 shakes over a three-month period. Here's how:

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*The actual numbers vary quite a bit because there is plenty of room for trainers to impose inconsistent and repetitive requirements, but I believe these estimates are realistic.

That averages out to seven shakes every single day for every single recruit (632 / 90 days), which adds up to millions of shakes annually! Again, if all this consumption was legitimate, Herbalife would be a reputable and impressive business. But it's not - it's part of a nefarious plan to bring low-income distributors (and their friends and family) into Clubs to share the cost of admission to this deceptively promoted American Dream.

Some claim that the motivation of these customers doesn't matter - consumption is consumption. But the courts and regulators see it differently.

Since the beginning of this Wall Street battle, the Direct Selling Association, which represents Herbalife and other MLMs, has pointed reporters and analysts interested in evaluating whether Herbalife is a pyramid scheme to a 2004 advisory letter issued by the FTC on the question of distributor consumption, which states: "Much has been made of the personal, or internal, consumption issue in recent years. In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme."

Herbalife has leaned heavily on this letter and, in fact, the company now calls its distributors "members."

Yet, on June 2, 2014, an appeals panel upheld a decision that BurnLounge, an MLM that sold downloadable music, was a pyramid scheme. BurnLounge had appealed an earlier ruling, in part, by citing the 2004 letter and arguing that its distributors should be considered customers. The court rejected the argument and pointed back to the 2004 letter, stressing that the relevant passage on internal consumption must be read in its entirety: "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 other words, motivation does, in fact, matter. Regulators and courts want to know why people are consuming a product. Are they consuming it because they like it and would choose it over other products based on price, quality, brand, the overall experience, etc.? Or, is the real motivation behind the purchase of a product "the right to participate in a money-making venture"?

The Club 100 system is fiendishly clever. It ensnares countless people all over the world in Herbalife's web, drains them of their time and money and, best of all (from Herbalife's point of view), results in a great deal of consumption of Herbalife's products, which makes it much harder for regulators to detect and shut down this sophisticated pyramid scheme. Finally, it is clear why we don't see very much Herbalife product stacked in garages or dumped on eBay, and why so little is returned to the company. Most of the product is indeed consumed, but not, as Herbalife would have you believe, by real customers but rather by those pursuing quotas established by the company's top distributors for people they deceive into pursuing a false promise of the American Dream.

Shut out by language and cultural barriers, by suspicion that we were compliance officers or immigration officials posing as Wall Street researchers, and, most importantly, by a system that created its own illusion, it would be three years before I understood it. Now, thinking back on that morning in Queens, I understand why the men crowded into that second-story Nutrition Club in Queens appeared to be such unconvincing customers - it's because they weren'treal customers. Instead, they were spending money they couldn't spare to drink a shake they probably didn't like to lose fat they didn't have in order to pursue (or help a friend or family member pursue) a "certification" for a "business opportunity" that doesn't exist for the overwhelming majority of people. They weren't customers in any traditional sense of the word; rather, they were paying the price of admission to a fraudulently promoted business, one shake at a time.

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 ofConfidence Game: How Bill Ackman (Trades, Portfolio) 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.

Disclosure:The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author has no business relationship with any company whose stock is mentioned in this article.

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.

The idea that there are a huge number of people paying to drink 5-7 plus protein shakes a day is - in my opinion - ludicrous. I challenge you to do that (as you would almost certainly throw up). It is also deeply contrary to what I saw on the ground. I saw real and regular consumers.

I don't know how to react here... Christine Richard can't speak their language, wants to ignore what they tell her when asked directly, spend three years researching and came to the conclusion that literally millions of people drink enough Herbalife shakes to throw up on a daily basis because they have been fooled into believing it is a route to prosperity.

The illusion here – and it has been repeated to me by other shorts – is that there is a fraud here that has taken in millions of people who are uneducated but we – white-middle-class liberals – can see right through it no matter what these people say.

It is the line of someone who sees facts-on-the-ground that differ from their thesis and distorts those facts to come up with a new thesis.

One Latino correspondent in Miami was so offended by this he started sending me pictures of clubs in Little Havana. Here goes.

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The club in question is run by the guy on the left’s wife [i.e. the wife of the senior policeman]. The club has about 280 visitors a day (which makes it an acceptable business) about 40 of whom are uniformed cops. The club also has a cycling group associated with it. Ray [the guy on the right] told me it was an alternative to the policeman’s sedentary with doughnuts diet.

This - with real consumer doing a shake a day - is the model on the ground. It is a repeated pattern, easy to find.

Clubs with middle class customers are rarer – but they are generally pretty nice.

Clubs entirely in poverty struck neighbourhoods reflect their community. The clubs in Queens are a fairly gruesome affair. You need about 60 visitors a day to make minimum wage and the clubs get 50-70. You can easily find people who work long hours for less than minimum wage.

When you talk to these people they think it better than working in a fast-food joint. They socialize with their friends, they think they are doing well, often they have young kids playing in the back of the club. The more middle class the area the larger the clubs tend to be (but some clubs in Malaysia are huge). The club above (with the police) is apparently 240-280 visitors a day - which winds up being far better than minimum wage. The cops believe in the business opportunity - without stating that they will get rich from it. However as most hedge fund types have visited only Queens (if they have visited any) they see only the gruesome.

Clubs in China

Multi-level marketing schemes in China are illegal. Direct selling organisations are not. The differences are subtle [is Avon a direct seller, or a multi-level marketer?]. But the origin of the difference is not subtle. In China hierarchical structures involving lots of people not under the direct control of the Party are illegal. Strangely Bill Ackman (Trades, Portfolio)'s China presentation presented the Chinese MLM laws as about consumer protection whereas they are about Party protection. [If consumer protection were so important why are most Chinese correctly convinced their food chain is compromised?]

Anyway I visited Herbalife distributors in Beijing without permission from the company, sent my notes - including some concerns - to the company and some large shareholders - and then with permission of the company went to visit distributors in Dongguan (in the Pearl River Delta). The Dongguan visit was on the same day as my visit to Hanergy in Heyuan. [Link.]

The distributors I was taken to in Dongguan were particularly successful (the most successful in the area) but apart from that the features were mostly unchanged between Beijing and the South.

Here are my contemporaneous notes of my trip to two distributors in outer Beijing.

(a). The price point for a Herbalife diet plan is a about 2X America. This fits with my observation that everything is overpriced in China and the currency is just flat wrong - but it is kind of disconcerting.

In America Herbalife meals are cheaper than the meals they replace. A $5 stop at a club to drink all three (aloe drink, tea, shake) is cheaper than getting equivalently full at Burger King. That is emphatically not true in China - where the meals are maybe 5X as expensive as the meals they replace and if you are middle income white-collar in Beijing then the expense of a two meal per day replacement diet is large compared to income. And if you are blue collar working class in Beijing it is 100 percent of income. This means that the product is not for the working class in China and it limits its size.

I should note that this was the thing about the Beijing stores I found most upsetting. In American as in Israel and in most other markets Herbalife is cheaper than the meal it replaces. Bill Ackman (Trades, Portfolio) (falsely) describes it as expensive and ripping off the poor. But Herbalife clubs - rather than a gym and personal trainer - are the way the poor get in shape. And it is a very cheap way.

Pricing in China limits that market. Herbalife is necessarily a middle income product.

(b). The second observation is that the clubs are quite different from the Mexico/USA clubs even though the people there thought the model came from Mexico. In the Mexico/USA clubs you walk through the door and drink "all three". It is a sit-around-and-chat model. The clubs are pseudo cafes - but you swap coffee for diet products. In this case none of the three clubs would sell me a single shake. Indeed it was very difficult to get them to sell me anything at all. What they wanted to do - and it seems to be standard - is that they measure your fat and other body measurements (standard electro-conductivity scales) and then put you on a diet plan. The diet plan is 7 days - but they then try to renew you for 90 days and then - presumably at a lower intensity - for a longer time thereafter.

Here - for the record - is a photo of me getting measured up for a diet plan (which you might unkindly note that I need).

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And this is the club which actually says Nutrition Club in English... [This club is about 15 kilometres from central Beijing.]

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China is still a daily consumption model - but there was less direct oversight of the daily consumption. The idea of buying a cannister of diet shake was sort of foreign to them. I did so though and I paid full retail - 550gram cannister for 329 Yuan (52 USD). This is a $26 retail price normally. And they were deeply reluctant to sell it to me.

(c). Both clubs were well appointed. The name Herbalife did not appear on the door (as per usual) and the staff were flat-out good looking. Young, groovy well dressed. This is contrast with the Hispanic clubs in New York where the owners are usually poverty struck by New York standards. These people would not look out of place in middle class Sydney - and indeed would be considered good looking.

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(d). We asked how many customers they had. Both said 40 – and at the time I was not sure I believed them. [I should note that 40 turns out to be a magic number – and I probably do believe them in retrospect.] In the time we were there (Sunday, good weather) a couple of customers came through both shops but did not stop around.

(e). There was almost no inventory at the stores. They told us that the ordering process is that the customers have a number - and they order online. The product is delivered direct to the customer and the company has a warehouse in the major cities so it is next day delivery. The lack of inventory is kind of important because if this is the model it is 100% safe against being called a pyramid under US law (as the sales are clearly to end customers and there is no inventory loading...)

I cannot stress how important this is. There is no inventory anywhere in the chain that is not a company owned warehouse in China. The company is completely immune to a pyramid allegation in China - and if this were the model in the US there would be no possible allegation either. The Ackman assertion that the entire global business is a pyramid is falsified by this fact. The fastest growing part of it has no pyramid features at all.

(f). At one stage we asked how much you [the distributor] got when a customer placed an order - and it seemed to be between 15 and 30 percent of the sale. [They showed us a remuneration scale I did not understand - but strangely all the distributor cuts seemed below the US. For instance they told us the cheapest a distributor can buy it is 30% discount - but outside China a sales leader can buy it at a 50% discount.

We later discovered that the direct selling rules in China limit the retail margin to 30 percent - but everywhere outside China the retailers doing serious volume (i.e. greater than about $4000 worth per year) buy the product at a 50 percent discount. The company does a few things which seem to circumvent this rule - and it pays other commissions for "activities".

The second club we saw was in a Greenland development. Greenland is a particularly delusional listed Chinese property developer.

The building was five years old and probably about half vacant. The downstairs was never tenanted and was falling apart. Here are few photos.

First the building...

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This was a typical downstairs tenancy.

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Like most heavily vacant buildings in China doors featured heavy duty bicycle locks. [I have seen hundreds of such locks...]

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But there was an occupied section and the "club" was in a small room on the fifth floor. Again there was limited signage on the door - but your chance of finding this club from the street was approximately zero.

Still there were customers who visited whilst I was there.

However this was a not a club where people sat down and had shakes and chatted. Instead the club clearly organised exercise activities. For example it took people hiking in the hills outside Beijing. In China this is an entirely saleable proposition... there are no hiking clubs in Beijing - and clubs per-se are very hard to organise within Party structures.

There were pictures of activities on the walls. The Dongguan club I went to had pictures of going to the beach - which looked very attractive and was about 70 km away. A bus would be hired. The company paid for these activities (supplementing the 30 percent retail commission that was paid) and senior distributors are paid more. You could - if you were aggressive about it - construe these payments as breaking the direct selling law in China. But I do not think that would be the right interpretation.

The organisation is extremely strictonhow these activities are organised - because I think they are the main selling point - but they are also the point at which the club gets together large numbers of people (and hence runs the risk of offending the Party). The Dongguan club (and the management in Dongguan who I met) told me they had to ensure that all activities were limited to 40 people - a number which did not offend the Party. It was clear that any and all rules about gathering of people were the rules they were most keen to observe.

Strangely both Beijing clubs we visited claimed they had 40 members. 40 members was a number that was repeated in Donnguan - and seems to be the limit of the number that you can take on one of your activities. We did the maths and with 40 members you make quite a good living in China relative the alternatives available. [The people who ran the second club had previously been hair clippers and talked about life with scissors.]

The Dongguan club differed from the Beijing clubs in a couple of respects. Firstly it was more successful - and the person claimed about 130 members - but told us that he never organised a group of more than 40. [It was the most successful club around and the company chose it for us.] Moreover it used to be in a cafe - so it had a bar at which people could and did sit around drinking shakes. This is not like clubs in other countries though - the number of people who drank shakes there would never have exceeded half a dozen. The shakes were mostly drunk at home. The owner told us the bar was not installed by him but the previous tenant at the shop.

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The club however would accept deliveries on behalf of its customers - and these were placed in lockers at the club. The customer's name was written on them. The distributor held no inventory.

Here are the lockers...

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And here, inside the locker is customer product with their name on it. This product was opened - and the customer came in irregularly and had a shake with the owner and/or some friends.

Continue on Part III