Click here For Part II

As a summary - the business in China is not in the long-run as attractive as the business in say Israel - because it is much harder to provide the social aspect and a sense of community in a country where large gatherings tend to raise the ire of authorities. But the market is huge (there are millions of overweight people - the victims of having four grandparents per grandkid). And there is plenty of growth left.

Alas it is also - because it is relatively expensive - not a product for the very poor in China. This probably eliminates half or more of the potential market in China.

The remuneration structure

One of the more controversial things about Herbalife is the remuneration structure which makes a few distributors very rich and can remunerate a distributor down an endless chain of recruits. In other words if A recruits B recruits C recruits D recruits E all the way down to Z it is almost inconceiveable that A has anything to do with Z - but A is (sometimes) entitled to a proportion of purchases by Z or even purchases by Z's customers.

The endless remuneration scheme is tied to get-rich claims by some distributors and is argued by Ackman and his supporters to be evidence that this is a pyramid scheme designed to enrich the people at the very top.

Alas - and I have proved comprehensively - the key Ackman researchers did not understand the remuneration scheme.

I posed a question and gave people about ten days to answer it. This was the question.

Imagine you were the very first Herbalife distributor and you recruited three people and they - eventually and through their downline - recruited the millions of people who now consume and/or distribute Herbalife.

And also presume you did nothing else for the rest of your career. You just sat there and collected the "recruitment rewards" or the "royalty checks".

Roughly how big would your income be now? And from how many levels would you be collecting your income?

Surprisingly nobody except some distributors who read my blog got the answer. [The distributors were fast and accurate.] Cristine Richards - Ackman's key researcher - wascomprehensively wrong. Here is the answer I gave:

If you are a base level distributor you buy the product at a discount of up to 42 percent. You sell it at retail. You make a margin.

At some point you become a sales leader. A sales leader is entitled to buy it at up to 50 percent discount. You can NEVER buy the product at a higher discount than 50 percent.

But the sales leader is entitled to a royalty. The royalty is paid three levels deep. A recruits B recruits C recruits D recruits E then A is entitled to 5% of BCD but not E's sales. B is entititled to 5% of CDE sales. That way 15 percent more is paid out.

This you are always entitled to - three levels deep.

After that there is a "production bonus". These are up to 7% of sales based on your level. However if someone in your down-line earns 2% production bonus then you are only entitled to 5%. And when your down-line is long and successful enough the entire 7% will be earned below you. You will be blocked and receive no income.

After that and if you are senior enough you may receive the Mark Hughes Bonus - typically 1% of all sales paid infinitely deep in the sales structure. However if someone in the Chairman's Club is below you (and this happens) then you get blocked on that too. So you will receive no Mark Hughes bonus.

The person I describe could never be in the Chairman's Club (to do that you need 5 people below you to make a certain level) but someone who was very early and has done almost no recruiting will almost entirely be blocked on the Chairman's Club as well.

So lets calculated the answer...

They do no sales - so they get no retail discount.

They have people three levels below them - so they receive 5% of their production - but their immediate network is either senior and doing few sales or sclerotic). This is the only income they get - and it is 5% of three levels.

They are unequivocally blocked on the "production bonus" so they get nothing there and

They are not Chairman's Club or above because they recruited only three people - and if the recruited more they would be blocked for most of it anyway just because the very early guys have all been blocked out unless they kept growing their network.

So all they get is 5% of three levels down - which is likely to be trivial - probably less than $5000 a year.

Note the 50% plus the 15% plus the 7% plus the 1% is the famous 73% payout ratio. It all gets paid - just not to the foundation recruiter. In fact it gets paid to people they recruited, people who worked hard to build networks and make more sales.

It is worth examining how you qualify for the senior levels in the sales structure.

To become a sales leader you need to sell 4000 volume points (roughly $4000 worth at retail) in a year. After that you become entitled to organizational volume - volume from your three-sales-leader deep downline.

If a regular customer replaces 400 meals a year and consumes 600 volume points then you should be able to do this on about 7 regular customers.

To stay a sales leader you need to requalify every February.

There are about 350,000 sales leaders globally and a little over half requalify. The average sales leader does many times the required volume. [The number of sales leaders being recruited is currently falling but the retention rate for sales leaders is rising. The reasons for this trend are discussed below.]

To make Presidents Team and be entitled to production bonus is fairly simple - but it looks awful hard to do. You need to get 200,0000 volume points per month for three consecutive months in your "organization" - that is three sales leaders deep. In other words three layers deep you need to be replacing somewhat over 100,000 meals per month - and that would require say 2000 people on a regular diet.

This could not be done by inventory loading because you need to do it for three consecutive months. The fact that anyone qualifies as a President's team member suggests the core Ackman thesis is wrong. However there are between 1-4 qualifications globally per month. Quite a few people have met this - and people are building new and sustained organisations fairly regularly.

There are many dans in the Presidents Team - and to reach the highest dan (and get the maximum production bonus) you need to be doing 1 million volume points per month in your organisation.

To become Chairmans' Club you need five separate Presidents' Team members below you (I am not sure what level of the Presidents' Team they need to be). This can't be done without bringing huge training and infrastructure to your Presidents' Team aspirants. It seems extraordinarily difficult to qualify as a Chairmans' Club member but most years 1-2 people make it. When I have met these people they are as organised and competent as the senior sales staff at say Oracle. There is a high degree of professionalism required to do this.

There is one level above that - so rare it is almost theoretical. That is "Founders Circle". To become Founders Circle you need ten Presidents' Team members of the highest dan in ten entirely separate downlines below you. To my knowledge only four people have ever achieved this. If there is a new ascension once a decade I would be surprised.

The remuneration system is - in my opinion - a work of genius. The senior staff have to build huge organisations below them and do huge amounts of mentoring to succeed. And then they have to continue to do it or their income tails off to zero fairly rapidly. If they do not keep working their downline eventually has people rise to their level and they are blocked from receiving income. Herbalife senior positions are a golden-treadmill - where people wind up working huge hours to maintain their network and to make sure they are not blocked.

The compensation plan and the ability to know - this is a perfect stock to research

To make this compensation plan work the company has and requires a very comprehensive (Oracle) computer system. Moreover distributors have access to their part of the system - so if you are a Presidents' Club member you can see everything in your downline. You can see how much they are ordering, their address, the repeat orders, who they have recruited. Everything.

This is a necessary part of running a Presidents' club organization. The senior distributor sees a sales leader whose sales are rapidly increasing they can find out why - and spread the good word. If a sales leader's sales are dropping off you can call in for some mentoring. This is all done by a typical Presidents' Club member.

The Presidents' Club member will also tell you accurately what is happening in their downline. They are not company insiders - they are independent contractors. And they will tell you how hard they work and how many people are in their downline and what gets people to sell and what does not because they are keen to recruit you and get you to do the same.

If you talk to six or seven independent senior distributors you can get a very accurate idea of what is going on in the company in real time.

This is a company where what would normally be "inside information" is legally and freely available for anyone who wants to talk with a bunch of distributors. It is the rare case of a company in which you genuinely can know the important details of sales and profits.

It rewards work. It is amazing to me that most of Wall Street has taken some interest in the Herbalife debate but very few people have done this sort of detailed work.

When I talk below (and I will talk below) about what is going on with sales and the change in the marketing plan - it is an area in which I can know. I may be "speculating" but it is very informed speculation. I have talked with enough distributors to know the basic trends. These distributors do not cover the whole company (I am not that well connected) but they cover a wide sample. For the moment all I am going to say is that this looks like a fantastic stock and about to get rapidly better.

Models of Herbalife distributors

Herbalife distributors vary according to the culture they are in. It could not be any other way – this is a distributed sales modelwhere local entrepreneurs work out what works in their community.

The model Wall Street is most familiar with is the “cafe-style” distributorship in Queens. These are very poorly equipped generally – often poorly lit and decorated. They reflect what it is like living as minimum wage workers in greater New York (for an affluent Wall-Streeter they are grim).

The (relatively grim) Queens clubs however are far the only model.

The China model that I saw at all three distributorsI visited in China was one where you had a fitness assessment, weight loss goals and the product was sent to you at home for consumption. The only meetings were group outings limited to 40 people. The 40 person limit was driven by Party rules which Herbalife complies with.

The Arab model (which I gather is repeated in Abu Dhabi and a few other places) is a group-hug model. The club is held in someone's very cheap space but includes group discussion and group exercise. [There are clubs in Abu Dhabi – but I did not get to visit them when I passed through. It has become a hobby to visit clubs in strange locations.]

One of the strangest models I know exists on the coast of Thailand and Cambodia. I mention it only because Bill Ackman (Trades, Portfolio) made a big thing in one of his presentations about how Herbalife had gone to Cambodia and hence was “targeting” the poorest people in the world. This has also become part of the SeekingAlpha hit pieces. It amazes me however that Pershing Square has strong views on Herbalife in Cambodia without going to look.

So let's look for him. These clubs on the coast of Thailand and Cambodia exist in the major sex-tourism destinations – places where men go and drink beer under the shade of some awning and are fawned on by younger women who want them to buy “lady-drinks” from which they get a commission. They will also go home with client if they pay a “bar-fine”.

Venues that are “beer bars” in the afternoon are sometimes Herbalife clubs in the morning, with older women running the club. The customers are overweight German and Australian expats [sexpats in the jargon]. You can find some of these clubs online complete with before-and-after photos of formerly fat Europeans sexpats. I won't do it for you – but just pick your sex-tourism hotspot and google it with the words “nutrition club”. I only raise this so bluntly because it is a clear and unequivocal place where Bill Ackman (Trades, Portfolio) was wrong. There are real customers. And they are not the poorest people in the world. [Besides, when the community that Herbalife is in is a sex-tourism community why should you be surprised that some entrepreneurial local distributor has targeted sex tourists?]

There are Herbalife clubs attached to Yoga studios. Think middle-aged housewives wanting to lose some weight and get some flexibility. They buy a little shake as well. More generally there are large fitness clubs which sell Herbalife. A fairly good example is in Sydney – it is called 24FitClub. The model here is often that there is a free fitness meeting in a park (usually on a Sunday morning). The fitness events also sign people up as Herbalife customers – and when you pay for Herbalife you are paying for the fitness event and the commodity shake. This clearly answers the short-seller question as to why people pay more than market for a commodity. [It is that they are not buying a commodity.]

Some of these clubs – particularly in Malaysia – are very large indeed (a thousand members has been quoted to me in one instance). There are clubs that meet in the park that have hundreds of members – and they also meet for fitness dances in gymnasiums (rented for the occasion). This works very well in places where women (Muslim) have a social restriction on dancing and the distinction between dancing and fitness exercises is blurred. They become Muslim dating clubs. [There are videos of such clubs on YouTube if you are interested.]

In every one of these cases protein shakes are being sold with “community” and in every case real customers exist. These clubs are a direct answer to the Ackman question – asked many times – as to whywould anyone buy overpriced protein shakes at full price (or even a 25 percent discount) when cheaper stuff is available online and in supermarkets? The answer: you get more when you buy it from a distributor.

Lead-sellers

As noted above, there is one point where Bill Ackman (Trades, Portfolio) seems to have some legitimate points – the former presence of lead-sellers in Herbalife's distributor base. In almost every multi-level marketing plan there are people who will sell “tools” to help you identify customers. These tools are usually something like a list of leads for people who have responded positively to a work from home business opportunity or the like. The “lead sellers” invariably sell the same lead many times.

Herbalife offers a refund on their products. As noted, the refund is now far-in-excess of Amway safe-harbour requirements. It has been increased to a full refund including postage.

Alas lead-sellers do not offer a refund.

Some people have paid $20 per lead. The money doesn't go to Herbalife – it goes to the lead-seller. There are plenty of examples of people who have been ripped off by lead-sellers at allMLMs. Indeed given the defences in the Amway safe-harbour (which is a 90 percent refund) the main way you can lose substantial money in a “goods” MLM is to lead-sellers. [Note that BurnLounge – which has been found to be a pyramid – sold music burning services – and it is very hard to argue that these are not consumed when delivered and refunds were not offered.]

Fairly early on in the Herbalife saga (early 2013) the company banned any lead-sellers from the organisation. [You were fired as a distributor if you were found to be selling leads.] I have not tested this hypothesis by finding someone who sells leads and seeing if they get fired – but Shawn Dahl and other lead-sellers left Herbalife. The company announced at the time that it would have a “low-single-digit negative effect on sales”. Truly if you look through the quarterly sales you can't see it. This was the first (of many) changes in the distribution rules that have had a negative – albeit temporary – effect on sales growth.

I have visited manyHerbalife distributors – and I cannot find “victims”. One Hispanic President's Club member I spoke to said he knew no Hispanic “victims”. His customers ran communities – rather than being solo-operators who thought they could just sell stuff from home.

Field sales (and Mexico)

Go back to the 1970s when the Amway decision was made. Payments over the phone were difficult – not everyone had a credit card. Deliveries of small parcels to millions of individual customers were impossible. These were the days before Amazon and ubiquitous parcel delivery.

In those days – and it is the environment that permeates the Amway decision – the distributors took very large deliveries (half a garage full) and they in turn made deliveries to their customers and even small distributors. Most end sales were made “in the field”.

This of course left the possibility that the distributor would be left with a huge amount of inventory and could really only make money by persuading other people to similarly take a huge amount of inventory. It was in to this environment that the Amway safe-harbour rules were designed. Provided the company could convince that there were real customers (the 70 percent external rule) and that you could not get stuck with inventory (a 90 percent refund rule) then you were safe against a pyramid accusation.

The 1970s conditions no longer exist in America. UPS and credit cards are ubiquitous and it is entirely possible to make deliveries directly to end customers (as they do in China) and also to accept small payments from end customers.

Until very recently there were not widely available payment mechanisms in many developing countries. [Smart-phones have to some extent changed that.] To this day accurate and timely delivery of small parcels is not available.

Many of Herbalife's distributors still live in countries with difficult delivery systems – and a few years ago Herbalife had never made a direct sale to more than a million of its distributors. Instead these distributors simply purchased from other distributors. Sales from other distributors are called “field sales”.

A field sale is a legitimate way of distributing product in countries with poor distribution networks – and indeed they wereonce common in the USA.

However they come with several difficulties for Herbalife. I will illustrate by example.

One difficulty is that field sales make it relatively easy to subvert the distributor networks... Cristine Richard in her article about “field sales” quotes a problem from several years ago in Mexico.

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)

This means real customer were buying real product but they were doing it in a way that circumvents the standard distributor network. Herbalife goes to extraordinary extents to protect distributor businesses (for example it will not allow online sales). The purpose of this (as described above) is to protect a distributor's “second sale”. Herbalife will ban distributors for behaving like this – and this disrupts sales and selling. If there were no field sales this would not happen.

More importantly field sales can be used to game the promotion rules at Herbalife. To become a Chairman's Club member you need to get five distributors below you of a certain level of President's Club. This matters because when you do so you block the Chairman's Club member above you for part of the royalty – and so getting a fifth President's Club member below you matters.

To game sales just shift-them around a little – and do some compensation of the person you shifted from. It is tricky but can be done in a field-sales environment whereas it cannot be done in a direct delivery environment.

There was an incident in Argentina a few years ago where this happened. There was an ascension to the Chairman's Club (thus shifting around considerable royalty entitlement) and this ascension was disputed and then reversed. To say this caused ructions in the distributor network is understating it. People did not trust each other any more. [I gather from discussions that this was not the only such incident – but I cannot vouch for others...]

There is a final problem with field sales – and this is particularly evident in Mexico. If all the sales are field sales Herbalife has far less control of and ownership over its network than is desirable. In Mexico there are three senior distributors who have built a network of distributors that cross the country. This network of distributors can do same-day deliveries to most of Mexico – which is darn useful – but alas comes at a cost to the company which is that they have ceded most the power to the distributors. Herbalife does not have a personal point of contact with their customers.

Importantly the widespread availability of payment networks in the developing world (via smart-phones) has allowed Herbalife to fix this – getting much more detailed information on its network and gaining control over its distribution. This is a substantial strengthening of Herbalife's business – but it comes at some short term cost. The short term costs (described in more detail below) are evident in the accounts for the last few quarters.

Other rule changes

Whereas the rule change banning lead-sellers did not have an appreciable effect on sales, other rule changes have. They are – in my well-supported view – the reason why sales have been weak at the moment.

The rule-changes are superficially a response to Ackman. Specifically the company has insisted that multiple orders are placed (over time) to qualify as a sales leader (the key distribution level).

In the past you could qualify for a sales leader with a single large order of 4000 volume points (about $4000) or with several orders (totalling 5000 volume points) placed over a year. The large order was called a “success builder order” and was a key exhibit in the claim that the company was a pyramid scheme. After all – encouraging people to buy large amounts that they can't sell is a key feature of pyramid schemes and is the feature that the Amway rules were designed to ameliorate.

Recently the company changed this so that the only way that you could qualify as a sales leader was with multiple orders spread over some time. If you can't sell the first order of say $1000 then it is unlikely you will be stupid enough to make another $1000 order.

No pyramid scheme would make this change – but Herbalife has rolled it out over the world. They started in Russia and some parts of Eastern Europe and the Middle East (test markets) but have now rolled this out globally. [The Club in Israel described at the beginning of this post operated under the new rules.]

This rule change is a veryeffective defence to the Ackman claims – a pyramid scheme simply would not do this. And when talking the company presents this as one of the reasons why the scheme needs to be rolled out.

However I think this is only part of the story.

The second part of the story is that involves cleaning up field sales. You cannot enforce a multiple-order rule if the orders are field sales and the upline distributors just fulfil the order. They could – of course – take a single order and enter it in the computer system as multiple orders.

So the company made a very important change – one that will change the nature of the company for decades. It now insists that orders to qualify as a sales leader (the key distributor level) are placed with the company directly – and not via field sales.

In the United States this is almost no change. In Mexico it is huge. For the first time Herbalife will have a direct relationship with all of their key distributors.

Making it work however is hard. The company needs to get their own delivery network up to the standard of the warehouse network owned by the senior Mexican distributors. They have had to rapidly get something like 1200 company controlled and company stocked distribution points in Mexico. They did this effectively and quickly. [This is a company that really can execute – it is – on the ground – one of the best management teams I have ever seen.]

This dramatically strengthens their business.

However it has very notable negative short-term effects on sales. For a start slower first orders just – well – slowed down sales. There is no surprise there. This effect was visible ineveryjurisdiction and in jurisdictions where it was trialled some time ago [notably Eastern Europe] sales have bounced back.

How do I know they have bounced back?

Well some distributors in those areas have shared their data with me. This is one of those things about researching this stock. Because the distributors are independent contractors with good data you can get very accurate data from them. You can know.

Importantly the move away from field sales – particularly in Mexico - have resulted in the upline distributors destocking their warehouses and the company stocking their own. This will result in temporarily lower sales (as the distributors destock) and a permanent increase in inventory (as the company warehouses get filled). Cash flow effects are negative and it was these cash flow effects that were most visible during the fourth quarter of 2014. After those results were released the shorts (including Bill Ackman (Trades, Portfolio)) were crowing about falling cash flow. [See this SeekingAlpha article for an example.]

The real sales effect of the rule change

Herbalife's senior distributors don't just sit around and gather their checks. If they did they would shortly get blocked in the distribution chain. They are active sales people building distribution chains. In Mexico that meant many things including building warehouses.

However the main thing that senior distributors do is they mentor downline distributors. If you spend any time with a senior distributor you will see this in action.

When they get a new sales leader there is a lot of training involved. It is – frankly – a waste of their time if the new sales leader drops out quickly. If the new sales leader seeks a refund of product it is doubly a waste of their time as they do not get paid at all.

The key determinant of upline income is how many of their downline builds communities around them – how many build sustainable (albeit often small) businesses.

When you talk to distributors you find that their key determinant of success is a retention rate. Most people who join Herbalife drop out. Most sales leaders fail to build successful businesses. [This is true for all diet products – I do not think Herbalife is unusual here.]

But I have seen senior distributors for whom over 90 percent of sales are to repeat customers. There are enormous numbers of new customers – but the total sales to new customers do not add up to much. It is the retained customers that account for almost everything.

The distributors with repeating business are valuable and the core of their income. New customers are only really worth something to the extent they produce repeat business.

Now here is the rub. In the markets Herbalife tested with the requirement for slow qualificationas a sales leader the retention rate was higher. Quite a bit higher. And the upline distributors spent much more of their (limited) time training people who were successfully building repeat businesses. And this had a sort of snowball effect on sales. The first effect of the rule change was that sales fell.

After that they grew. And then they started to grow at an accelerating rate. Distributors qualified under the new rule are (a) much more likely to produce repeated sales and (b) much more likely to recruit people who in turn produce repeat sales. The distributors are profoundly happy with the rule change – and they are seeing their income rise. The income-to-effort ratio is also changing favourably.

How do I know? Well distributors have the data. I said that above.

This is simply wonderful as a shareholder or potential shareholder. There is currently some weakness in Herbalife sales. Herbalife has guided for increasing sales in the second half of this year. If the trends here follow the test markets those increases are in-the-bag. Better – if the trends follow the test markets then not only will sales and earnings accelerate, they will accelerate at an accelerating rate.

Herbalife once exceeded earnings expectations for 21 straight quarters. Although the Ackman/Einhorn hiccup was in the middle of this – generally this was a very good time for Herbalife shareholders.

Here is the trick. If the test markets are a guide (and I believe they are) then that record will be repeated, but this time the earnings will accelerate. Big numbers are possible. I don't think anyone other than the wildest bulls expect accelerating growth from here – but that is a distinct possibility.

Summary

At something close to 20,000 words that is long enough. I will be getting off the plane shortly anyway. So here is a good place to finish.

What we have however is a short-case built on arguments that do not fit the facts-on-the-ground.

On the ground this is an ethical company that does good things and builds huge and sustaining communities around its products.

Moreover it is doing rational things that are short-term earnings negative but will strengthen the business and set the company up for not only growing earnings but accelerating underlying sales (and hence earnings) over the next few years.

Management is focussed on shareholders. Their execution is excellent (see the build out in Mexico).

And there is a 30 plus percent short interest in the stock.

And the starting price-earnings ratio is modest – considerably under the market average.

There isn't a better stock in my portfolio. It will eventually go well over $200 [even without short-covering]. The stock is indecently cheap now. And the company is of the highest quality.