Wednesday, January 28, 2015

A Coincidence That Was Too Good to Be True, That Was Too Good to Be True

After reading QTR's blogpost about Herbalife's stable gross margins I thought I'd offer an answer to the question he's posed: Is Herbalife's gross margin too good to be true?

All inset is a direct quote from Herbalife 2014 Q3.

Our “gross profit” consists of net sales less “cost of sales,” which represents our manufacturing costs, the price we pay to our raw material suppliers and manufacturers of our products as well as shipping and handling costs including duties, tariffs, and similar expenses.

While all Members can potentially profit from their activities by reselling our products for amounts greater than the prices they pay us, Members that develop, retain, and manage other Members can earn additional compensation for those activities, which we refer to as“Royalty overrides.” Royalty overrides are our most significant operating expense and consist of:
royalty overrides and production bonuses;

the Mark Hughes bonus payable to some of our most senior Members; and

other discretionary incentive cash bonuses to qualifying Members.

“Selling, general and administrative expenses” represent our operating expenses, which include labor and benefits, service fees to China service providers, sales events, professional fees, travel and entertainment, Member promotions, occupancy costs, communication costs, bank fees, depreciation and amortization, foreign exchange gains and losses and other miscellaneous operating expenses.

When you look at Herbalife's SG&A, its much clunkier over time than Gross Profit. Herbalife's gross profit is consistently stable, but what they report as Gross Profit fails to account for major currency swings, which simply show up in SG&A.

Its also important to remember that Herbalife's sells in many different currencies and consequently they break out net sales in local currency for the respective operating segment. For example, local currency sales in Mexico increased 3.5% in Mexico, while it decreased in South/Central America by 1.1%(including bolivar remeasurement). In Russia you can see that net sales increased 20.1%, even with a 15.3% move in USD-RUB exchange rates.

In short you can take issue with where Herbalife books the local currency effects(although I don't I just back out the effects), but that being said, I'd be more concerned if they had wild fluctuations in their gross profit than I would that this number is extremely stable.

Setting aside the distributor allowance and royalty overrides(which is their largest operating expense) for now, you have to appreciate that if they source in the US and manufacture in the US and ship out of the US, their gross profit should remain pretty stable. The big swings show up in the consolidated numbers elsewhere.

Coincidence averted.

But, like QTR, I too will defer to the reader to do your own research.


  1. Skeptic, you've been quiet far to long. That being said, it's easy to discern that QTR is just an Ackman lemming trying to make a name for himself. A close look at his recommendation to short Netflix at about $ 160.00 that later moved north to over $ 400.00 speaks volumes about his analysis.

  2. Why does the fact that forex gains and losses get booked in SG&A suggest to you that the gross margin is immune from currency swings? Revenue will still get booked based on market exchange rates (volatile), and COGS is still largely denominated in US dollars (stable). Shoeldn’t volatile revenue + stable COGS imply a volatile gross margin?

    Also, if you look at Herbalife’s Q1 2010 10-Q, you will find the following commentary, which shows that some amount of foreign exchange volatility is captured by the company’s gross profit accounting. Notably, the company explains its gross margin variance during the quarter was a result of “the unfavorable impact of remeasuring Herbalife Venezuela’s Bolivar net sales at the unfavorable parallel market exchange rate” and “the unfavorable impact of other currency fluctuations.”

    Gross Profit
    Gross profit was $478.2 million for the three months ended March 31, 2010, as compared to $419.3 million for the same period in 2009. As a percentage of net sales, gross profit for the three months ended March 31, 2010 decreased to 77.3%, as compared to 80.4% for the same period in 2009. The decrease was primarily due to $12.7 million of incremental costs related to imports during 2009 into Venezuela at the unfavorable parallel market exchange rate, which were recognized in cost of sales during the first quarter of 2010 as these products were sold, the unfavorable impact of remeasuring Herbalife Venezuela’s Bolivar net sales at the unfavorable parallel market exchange rate during 2010, as opposed to being translated at the official rate during 2009, the unfavorable impact of other currency fluctuations, and changes in country mix

    1. I think we’re getting in the weeds here, but I do not think Herbalife is immune from currency swings, and in fact HLF actually clearly states in their latest 10-Q that "total net sales will continue to be affected by fluctuations in the U.S. dollar against foreign currencies."
      We agree that their "cost of sales" should be stable because most inputs and outputs are on shore and I'd expect that local currency demand should be affected by currency fluctuations in relation to the dollar.
      In fact, in Q3 2014, the USD index moved against them 7.6% in the period, which certainly must have been a factor contributing the slowdown in their net sales(up only 3.5%) whereas local currency net was up 6.3%.
      This is another reason why their Volume Points system is a useful, although somewhat unfamiliar surrogate metric. VPs help track increases/decreases in local currency net sales. HLF defines net sales as: “Net Sales” equal product sales plus “shipping and handling revenues”, and generally represents what we collect.
      This brings us right back to "net sales in local currency,” which is important because it effectively translates current net sales (in USD) which flow through the subs into matching exchange rates.
      I agree that you are correct (and thanks for the link to the Q1 2010 10-Q) that some currency effects do show up in HLF's accounting. If you continue deeper into the 10-Q you refer to though, you see that this is an incremental charge that resulted because of an offset between:
      1) when they recorded a loss in their consolidated Income Statement because they remeasured their Venezuelan assets and
      2) keeping their non-monetary assets (i.e., inventory) at historical cost when compared to 2009.
      It’s because of this offset that we see the Bolivar effect flow through into the gross profit in your example.
      Transaction vs Translation
      We shouldn’t be mixing the aggregate effects of currency either. Demand is undoubtedly affected by currency fluctuations because something becomes more expensive in a local currency. That is an entirely different beast from a true FX gain/loss based on depreciation/appreciation of your locally denominated transactions. I’d argue that the variance resulting from a currency move in a foreign market is going to shake out in their SG&A and that variance in the local economics of demand will shake out in the VP numbers. I guess my point is that it’s true that we can observe some FX influence in the gross profit numbers, but because the FOREX exchange losses you are referring to consistently show up in SG&A that the magnitude of change in the gross numbers will remain relatively small in comparison to other companies that book it differently. In fact, in your example this resulted in a minor change of only 3.1% (which is still far lower than the 12% average variance QTR referred to).

  3. Shane, all of a sudden you come out of hiding with no excuse for why you decided to abandon ship. Curious to say the least. Fusion Research took you to task pretty good. You and Ackman first perpetrated your thesis on no retail sales and then morphed into every other possibility but the kitchen sink. Get real, desperate people do and say desperate things and you are not immune from such behavior. Using a NYPost reporter as a shill and associating with an ex-scientologist for forensic accounting is disgraceful.

  4. This is really a wonderful post.