Herbalife’s Top Distributors Hold Warehouses Full Of Product In Mexico – Why? by Christine Richard , Confidence Game, Seeking Alpha

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 of Confidence Game: How Hedge Fund Manager Bill Ackman 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.

Summary

  • Top distributors in Mexico have been buying huge amounts of product and purportedly selling it to other distributors, a practice Herbalife recently referred to as “field sales.”.
  • Field sales may comprise as much as 70% of Herbalife’s business in Mexico.
  • The existence of field sales and the company’s plans to crack down on them have been inadequately and selectively disclosed to investors.
  • Field sales and distributors storing enormous volumes of product in warehouses raise numerous red flags regarding Herbalife’s business – from inventory loading to channel stuffing and illegal and unfair business practices.

Herbalife Ltd. (HLF) Top Distributors Hold Warehouses Full Of Product In Mexico - Why?

Herbalife Chairman’s Club member Humberto Jaimes lectures at his training center in Tecamac, Mexico, which is filled with enormous volumes of Herbalife products

Herbalife has long denied that its products pile up in distributors’ garages. Yet in recent weeks we’ve learned that the company’s products are being stockpiled in warehouses across Mexico.

Investors and regulators should have plenty of questions about this practice, particularly given that the company has gone out of its way to suggest that this type of activity had ceased in Mexico. It’s only in recent months that the company began to disclose (though very selectively to a group of sympathetic analysts and investors) details about a practice it calls “field sales.” The practice involves top distributors buying huge volumes of products from Herbalife, storing them in a network of warehouses across Mexico and then selling them to lower level distributors.

The business isn’t supposed to work this way, and the fact that it does raises numerous red flags.

Framed as a Qualification Issue

The phrase “field sales” first emerged in a November 3, 2014 research report penned by Pivotal Research analyst and Herbalife shareholder Tim Ramey:

Starting February 2015 (volume month), field sales will NO longer be eligible toward Supervisor Qualifications. All Supervisor qualifying orders must be purchased directly from Herbalife (for both PPV & DLV). Field sales from a Supervisor to Member will not count toward Supervisor Qualification.

Barclays analyst Meredith Adler, whose firm has acted as an underwriter for Herbalife, also seemed to know, in advance, that the end of field sales was going to figure in the company’s performance, though her expectations for the timing differed from Ramey’s by a few months. Adler, as Ramey had done in his research report, put a positive spin on the discontinuation of field sales in her February 23, 2015 research report:

Starting on November 1, HLF eliminated the use of field sales in Mexico, meaning a distributor can only become a sales leader if he/she buys directly from HLF. As a result of this change, volume points were flat in 3Q14 after growing about 6% in 1H14. However, this change has long-term benefits, including ensuring sales leaders are properly trained and giving HLF better oversight of sales in Mexico.

During the company’s first quarter conference call on February 28, CEO Michael Johnson told investors that a number of changes regarding distributor qualification, including the field sales crackdown, were weighing on sales in Mexico and would likely continue to be a drag on sales during the first quarter.

During the call, Herbalife took only a few questions and no one followed up on the field sales issue – at least publicly.

Mexico as a Role Model

That’s surprising because what happens in Mexico is crucial to understanding Herbalife’s broader business prospects. Under Johnson’s tenure, Mexico has been touted as a roadmap for Herbalife’s expansion around the world.

One of the company’s oldest and largest markets, Mexico experienced a period of rapid growth following the introduction of the Nutrition Club model in about 2004. According to the company, Mexicans flock to Nutrition Clubs for good nutrition and a sense of belonging; for a few dollars a day, club members receive a Formula One shake, Aloe water and tea. Later, members may seek to open their own clubs, expanding the network of family and friends and neighbors who are exposed to the products and the business opportunity, ostensibly creating an endless cycle of expansion.

Herbalife had 37,000 nutrition clubs in Mexico at the end of 2013, making it far and away the leader in implementing this business method.

Source: Financial Times

Management has said that the success of Nutrition Clubs is proof that the company does not operate as a pyramid scheme. If you accept the company’s statements at face value, products are not being stockpiled in distributors’ garages; they are being consumed daily by customers in thousands of Nutrition Clubs, proof that Herbalife has real customers.

But it hasn’t been all smooth sailing in Mexico.

Ethical Issues Arise

In January 2007, Herbalife held a conference call to announce that it was lowering guidance for Mexico. Management cited various compliance and logistics issues.

It seemed that the company’s infrastructure in Mexico was insufficient to distribute the products beyond several urban centers. During a subsequent earnings call, Herbalife executive Richard Goudis explained that the compliance problem related to “illegitimate” distributors who had infiltrated Herbalife’s ranks and were engaged in “non-compliant activities.” These activities had been fueling Herbalife’s growth. Goudis explained:

What was happening is, in markets or in states where we did not have distribution points, very entrepreneurial distributors were driving a pickup truck to a distribution center, picking up product and then selling to people that were not in their organization. (Bank of America Securities Consumer Conference, March 12, 2009)

Goudis’s description sounds a lot like “field sales.” The day after the January 2007 guidance adjustment, Herbalife’s stock dropped 24%.

Creating a Vast Network

Herbalife supposedly had solved its compliance and logistics problems. The company terminated 10% of its Mexican distributors to get rid of the bad actors, and it set about creating more authorized locations at which distributors could purchase and pick up products. The company expanded its own network of warehouses from two locations in 2006 to twenty-one by 2009.

In Q1’2010 Herbalife partnered with Waldo’s – a Mexican retailer – creating an arrangement that allowed distributors to pick up products at approximately 300 retail locations. Herbalife President Des Walsh explained how innovative distribution strategies were replacing the inappropriate practices of the past:

[I]n remote areas where it may take several days for product to reach them, and where it’s not practical for them to have visited in person one of our 20 sales centers, what would happen in that area is that an upline distributor would effectively carry an inventory of product and they would actually sell that to their downline. … [Now] you’ve got the increased access with the additional Waldo’s location that are causing those distributors to switch their patterns and buy directly from the company and pick

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