Herbalife Ltd. (HLF): Is The Selloff Overdone?

According to Ackman, the problem with Herbalife’s financial statements is that retail sales “assume 100% of sales made by distributors are made at the inflated suggested retail prices”. Ackman’s findings show that actual retail sales for Herbalife’s products come in around 65% of the suggested retail price. Ackman then outlines adjustments to Herbalife’s income statement that he feels better convey the company’s true recruitment/reward spending.

These adjustments include the fact that that internal consumption should not be counted as retail profits, where the problem lies in the fact that Herbalife does not “track how much product is resold to retail customers…nor the sales outside the network.” Another big adjustment by Ackman is taking into account the wholesale commissions paid to distributors, which Herbalife tries to conceal to boost retail profits. The billionaire also believes that Herbalife has buried recruiting rewards in SG&A expenses.

Taking into account all of these adjustments, Ackman believes that the nutrition company paid out 92% of its 2011 retail profits in the form of rewards, compared to the stated 31% in its financial statements. By all accounts – under Ackman’s ad-hoc scenario – Herbalife would be considered a pyramid scheme given “participants obtain their monetary benefits primarily from recruitment rather than the sale of goods.”

Digging deeper into the pyramid scheme allegations, Ackman estimates that 93% of Herbalife distributors make $0, and only 0.04% make more than $100,000. Further piling on the allegations is Ackman’s estimation that the top 1% of Herbalife distributors receives 88% of all the rewards.

Ackman points out that Herbalife claims to have the highest research and development standards in the industry, but in looking at an excerpt from the company’s 2011 annual report, it shows that Herbalife’s “research and development costs were expensed as incurred and were not material.” Ackman has trouble understanding why Herbalife’s products are so successful, especially when the company “spends ‘de minimis’ dollars on advertising.” He believes the advertising money deployed actually goes toward promoting the company’s name and logo rather than its products.

So what can investors do?