Last week when I wrote about Youngevity being the MLM Scam of the Week, I was mostly joking. I don’t really expect to have a noteworthy MLM article every week. However, I couldn’t resist this week. A company losing 3 billion dollars is significant. It’s not often that the Wall Street Journal or Business Week write about an MLM company. However, that was the case with HerbaLife earlier this week.
Let me start off by saying that I’m not very familiar with HerbaLife. They’ve been mentioned in connection with my MonaVie and Nerium articles, but I haven’t researched them like those other companies. With that understanding in place let’s get to the news.
Earlier this week HerbaLife (ticker:HLF) announced their earnings and had a conference call. The earnings for the quarter were down a little, but the outlook for the future was raised. The consensus was that it was more or less business as usual at HerbaLife. However, during the call Greenlight Capital president David Einhorn asked a few pointed questions:
“First is, how much of the sales that you’d make in terms of final sales are sold outside the network and how much are consumed within the distributor base?”
“What is the incentive for supervisor to sign somebody up to become a distributor as opposed to – if they’re just going to consume for themselves as opposed to just selling them the product for the markup. How does the distributor – how does the supervisor come out better?”
“When you had your previous 10-K, you disclosed three groups of distributors at the low-end. You called 29% self consumers, 57% small retailers, and 14% potential sales leaders and then that disclosure did not repeat in the subsequent 10-K. So, I got two questions, first of all how do you track that and how do you characterize and know which ones are which? And second, why did you stop disclosing that in the last 10-K? Is that something that you stopped tracking or just stopped disclosing?”
These questions put the stock in a free-fall. Over the last 5 days it lost 35% of its value dropping from $70 a share to 46. I read some of the business blogs and they didn’t seem to know what make of these questions. For example, MarketWatch just blamed it on the fact that Einhorn was asking them. HerbaLife responded by saying:
“The fact that recognized short seller David Einhorn asked questions on the call put pressure on Herbalife’s stock price. Mr. Einhorn’s questions raised no new subjects or concerns. Our business fundamentals are very strong and we are confident in our financials, our disclosures and our network marketing business method.”
So we are to ignore the questions themselves and just chalk it up to who is asking what their motives are? “I don’t think so… Homey don’t play dat!”
There are two fishy things going on here.
First, within hours of the call, the Law Offices of Howard G. Smith announced and investigation on behalf of shareholders of Herbalife. That was pretty quick. I think Einhorn already knew that it was in the works and this was the reason for his questions. This would mean that Einhorn isn’t the cause, but in fact just a messenger. Very few news outlets reported on this investigation. (The other side is this is that maybe the Law Offices of Howard G. Smith just jumped on the hot button issue very quickly to get some business. I think the former is more likely.)
Second, the point of the questions, even though it isn’t explicitly expressed is determine if HerbaLife is a pyramid scheme. You can look at the questions and there’s nothing in there that says “pyramid scheme.” It’s not a surprise why much of Wall Street missed it and didn’t make the connection. CNBC did a segment with analyst Tim Ramey at D.A. Davidson:
As you can see the interviewer (I forget his name) says the questions are about the margins of selling the product at retail or wholesale. Tim Ramey corrects him and says that it really isn’t about margins at all. Tim Ramey upgraded the stock after the sell-off and suggested that people should buy it hand-over fist. Ramey brings up the issue of customers vs. distributors saying (paraphrased), “If you are customer, you aren’t very smart, you should become a distributor to get that discount. The people who just want to buy the product become preferred customers at NuSkin/Usana or distributors at HerbaLife. There’s nothing wrong with that by the way.”
I beg to differ with Tim Ramey. There’s nothing wrong with being a preferred customer, but if the MLM consists of all distributors and not preferred customers there’s a lot wrong with that… at least according to the FTC:
“Not all multilevel marketing plans are legitimate. Some are pyramid schemes. It’s best not to get involved in plans where the money you make is based primarily on the number of distributors you recruit and your sales to them, rather than on your sales to people outside the plan who intend to use the products.
… Avoid any plan where the reward for recruiting new distributors is more than it is for selling products to the public. That’s a time tested tip-off to a pyramid scheme.
… Another sign of a pyramid scheme is if the money you make depends more on recruiting — getting new distributors to pay for the right to participate in the plan — than on sales to the public.”
The FTC says a whole more in a bunch of other documents. I’ve summmarized a few of the key documents and they all say, “MLMs must focus on sales to outside participants.”
Is HerbaLife a Pyramid Scheme?
With this piece of information, it is worth deeper at Einhorn’s questions – but I’m most interested in the first one. You can listen to the audio of the call here (scroll down to the video box) or read a transcript of it here.
When looking at that first question it becomes clear that when Einhorn asked, “How much of the sales that you’d make in terms of final sales are sold outside the network and how much are consumed within the distributor base?” he was really asking, “Is HerbaLife a pyramid scheme?” It is a very fair question and one that the FTC says you should ask of any MLM to make sure it isn’t a pyramid scheme.
HerbaLife’s response was “So, David, we have a 70% custom rule which is basically says that 70% of all products sold to consumers or actually consume my distributors for their own personal use.”
I’ve read HerbaLife’s response a number of times and it’s not helping me answer Einhorn’s questions. As best I can tell 70% of the product is sold to a combination of consumers who may be distributors or the general public. Who knows what happens to the other 30%… I guess it’s thrown in the trash? (For those who really know about MLMs, the 70% is not a random number that HerbaLife picked out of a hat, it is the percentage of retail customers a company should have as defined in a big FTC-Amway law case at the end the 70’s.)
Tim Ramey in the CNBC video above makes a good point. HerbaLife doesn’t really know where these sales are going. That’s tough poop for HerbaLife. They were the ones that created the compensation system. They need to be able to ensure compliance or change the compensation plan. I offer some advice here: How an MLM Can Show It Isn’t an Illegal Pyramid Scheme. The idea is simple. Don’t pay people for product sold to other distributors, but only those who are preferred customers not in HerbaLife. This ensures that outside sales are made and that it isn’t an endless chain recruiting system, which is what the FTC is looking for.
A day later after having time to think about it, HerbaLife had a more specific answer for Einhorn’s questions:
“The company said that at the low end of its distributors, 27 percent were people who bought products for their own use; 61 percent used the products personally and sold modest quantities to friends and family; and 12 percent signed up with the intention of seeking a promotion in the distributor hierarchy.”
Notice how the response is qualified to address the low end of its distributors. What about the high end? Is their reward for the recruited distributors more than their sales to the public? In every MLM I have looked at it is. And that would be a “time tested tip-off to a pyramid scheme” from the FTC quotes above.
Continuing on with HerbaLife’s response, they once again don’t give a clear answer to where the product is being sold. In fact shouldn’t the 27% “who bought product for own use” be included in the 61% “who used the products personally…”? This shouldn’t be a brain teaser. Some percentage of people buying the product are distributors and the rest are not.
I give analyst Gary Albanese at Auriga USA credit as he said Einhorn was asking how much product was being sold through to customers, and the company was giving an answer of how much was being consumed by distributors themselves.
My best analysis of this answer is that the 27%, the 61% and the 12% are all effectively sales to distributors within HerbaLife and not to end customers with the except of the “modest quantities sold to friends of family.” That modest quantity does not fit with the FTC’s repeated requirements of focusing a majority of sales to customers outside of the company. Therefore, the only conclusion I can draw is that HerbaLife is indeed a publicly traded pyramid scheme.
Finally, it is worth noting that late last year, a court in Belgium ruled that HerbaLife was indeed a pyramid scheme. Belgium’s laws for pyramid schemes aren’t too different than the United States.
Further Reading: If you are weird like me and find this kind of thing fascinating I suggest you should check out the full story on: MLMs Vs. Pyramid Schemes.
More Further Reading:
Days after I published this CNBC caught on to the what Einhorn was getting at published this article. It’s a very good read.
Fraud Files covers this Herbalife issue in depth as well.
Finally a court in California said that HerbaLife might be and endless chain scheme (PDF):
Moreover, in the Court’s view, Herbalife’s entire business model appears to incentivize primarily the payment of compensation that is “facially unrelated to the sale of the product to ultimate users because it is paid based on the suggested retail price of the amount ordered from [Herbalife], rather than based on actual sales to consumers.'”
I am surprised that a publicly traded, pyramid scheme, worthless herbal supplement, company had anywhere near 3 billion dollars in market capitalization to lose. That said, it seems unlikely it had anything to do with a few comments by a known enemy.
I was also surprised at Ramey’s comments. If there is no barrier to becoming a “distributor” and you can then get a discount on products you would have bought anyways; that seems like an incentive for more distributors, which seems like it’s against HL’s best interests.
Lazy Man says
Yeah, it is pretty shocking that they’d have that kind of market cap, but they make a lot of money.
Nah, HL wants as many distributors as they can get as they are their best customers. Perhaps they are the HL customers as it is unclear whether the distributors actually sell product or just consume it while they are trying to recruit others to make money.
All I’d like to say is that everybody in my family are herbalife distributos and we consume the product based on our needs. We also run a nutrition club from home where customers come to consume the products as well by paying a membership fee that covers the cost of the products. There are incentives from the company to buy the products at wholesale but its up to the individual distributor to decide how much he’d like to purchase for the month provided it will get consumed. The company has very limited returns by the way.
Lazy Man says
Thanks for the comment Sush,
I noticed that you mentioned consume three times in your comment and one about returns. This seems to stem from the perception that MLMs must not load distributors with excessive inventory. It should be noted that consumption of product does not actually factor into whether an MLM is a pyramid scheme or not, it is about the retail sales to people outside of the network like Einhorn was asking.
It sounds like your nutrition club satisfies the goal of having customers outside the network. However, your family is only one small view into the system. I don’t know how big your family is, but if everyone is in HerbaLife, that could be 4-5 distributors. That’s a lot of product that needs to be sold via the nutrition club vs. having just one distributor. The single distributor hearing about HerbaLife probably doesn’t run a nutrition club.
hi lazy man, I really like your article, before starting I am sorry for the mistake I will do I am french so i do a lot of mistake. I want to know if you have ever heard about ACN because you always talk about mlm with product and ACN is with services if you dont mind can you take a look at it ? thanks for your reply
Lazy Man says
I have heard of ACN from others who follow it. I haven’t looked into it myself, since it seems clear that many others have done all the work. One bit of information I found was at: http://www.pyramidschemealert.org/PSAMain/news/ACNScheme.html
Not sure if you caught it today but Herbalife’s CEO was on CNBC today defending Herbalife against being a pyramid scheme. Only part of his appearance can be seen here.
It seemed quite clear to me that CEO Johnson clearly understands what Herbalife is all about but most of the panel with the exception of Herb Greenberg seem to have no clue as to the facts of MLM. In fact Greenberg wrote an EXCELLENT article here.
So glad to see this getting some much needed attention.
Lazy Man says
I hadn’t caught that spot on CNBC. It is pretty amazing that he pretty much says it isn’t a pyramid scheme because they aren’t paying for recruiting… though HerbaLife pays distributors for products that are bought from those who have been recruited.
It’s odd that the CEO didn’t seem to have any recollection off the endless-chain scheme that the California court ruled as a triable case in 2009 (Also linked in the article above). However as long as he gets on CNBC and says that it isn’t a pyramid scheme, then that makes sense :-/.
The article on CNBC by Greenberg is interesting. I had included it in the article as an update.
[email protected] and Money says
WOW 3 billion dollars is a huge sum to get wiped out! Just goes to show that any suggestion of pyramid structures can cause absolute panic.
Lazy Man says
Yep, I got a couple of emails on that. Good work on people staying on top of things while I was out running errands today.
I love when people talk about the product like it would sell via any other distribution method. If that were the case, HLF would switch to a distribution method that maximizes shareholder value and not one that costs them several billion dollars.
CEO Michael Johnson claimed sales outside the distributor network were 90% in an interview with CNBC today. In the conference call in July, Einhorn asked the same question and was answered 70%.
Lazy Man says
I like this quote from that interview: “OUR CUSTOMERS ARE SOMETIMES CALLED DISTRIBUTORS THAT’S THE ONLY CONFUSION THAT WE HAVE. AND THEY ARE DISTRIBUTORS BECAUSE THEY GET A DISCOUNT ON OUR PRODUCTS.” (Sorry for the caps, but the transcription did that)
What he seemed to leave out is that the sales force are also referred to as distributors and the very definition of the word distributor aligns much more closely with that than “customers who get a discount.”
It is very simple to clear up this “confusion.” Don’t blur the line of distributors and customers. If someone’s intention is to resell the product and create a business they sign a distributor contract. If someone’s intention is to be a customer and get a discount, they sign a preferred customer contract.
There’s a big problem with the industry where one of the key defining characteristics of whether it is an illegal business (sales to people outside the network) is done on the honor system (i.e. the CEO throwing out the 90% number, which is quite oddly an extremely round number). I can’t think of another scenario where they ask the person alleged of committing illegal activity whether they are committing the illegal activity and take that answer as proof.
Herbalife stock down another 20% today, other MLMs such as Nuskin off double digits as well. Will this bring the attention of the FTC? Ackman welcomes Herbalife threat of a lawsuit as it will allow him access to non-public information to prove his point. Is this the beginning of the end to MLM in it’s present form? This is very important developments. I applaud the work of Einhorn, Ackman and Greenberg. Ackman is right when he says the world will be a better place without these predatory scams.
By the way, the stock is down roughly 20 points since the Ackman story broke. Ackman is short 20,000,000 shares, a profit of $400,000,000 (that’s $400 million). He considers making a profit off having anything to do with the damage that has been inflicted by MLM to be “blood money” and is donating all of any profits to charity. Good work sir!
Lazy Man says
I plan on writing a series of articles on these developments. This is by far the most significant development in MLM awareness I’ve seen in some time.
On CNBC he they did some math that made it out to be about a billion dollars. Ackman’s presentation is amazing… you can apply a lot of it to many MLMs. He covered many of the major themes.
Is anyone here surprised by the number of ad-hominem attacks on Greenberg and conspiracy theories about his motivations in the comments that followed his article? It’s the typical tactic of MLM-ers trying to deflect the spotlight from Herbalife and the evidence that it’s a pyramid scheme.
Lazy Man says
Also, if you’ve been on the website Seeking Alpha there were a bunch of distributors and people who were long HLF that kept on repeating financial information ignoring the fact that it doesn’t matter if its a pyramid scheme.
Forget the distributors and longs defending HLF, how about the analysts? Given thier resources shouldn’t they know better? See this article on seeking alpha. http://seekingalpha.com/article/1078621-in-defense-of-herbalife-arguments-against-ackman-s-short-thesis
My personal conclusion is that most distributors, longs in HLF and even the analysts don’t understand the business model (or should I say intent)or the damage that it has inflicted.
When Herbalife was ruled a pyramid scheme in Belgium in January, I brought this stock to the attention of a friend who I admire highly, is a money manager and former mutual fund manager. He deals mostly with large cap quality companies and Herbalife is not the type of company that would not normally hit his radar screen. He looked at the financials, liked the dividend, liked the growth, liked the longevity of the business, there was very little he didn’t like given the financial statement. He even joked (I think he was joking) that he might add it to his portfolios. My point is this is how the street can be misled without understanding the business model could very well be ruled a pyramid scheme and the eventual price be zero.
I’d like to address the claims by the seeking alpha story in defense of Herbalife.
The first defense, is how could Herbalife be a pyramid scheme and be in business for 30 years? There are a few considerations that could explain this. First, I believe Ackman’s presentation estimates that roughly 1.8 million people have been Herbalife distributors. The population of the US is roughly 350 million, so less than 1% have enrolled as distributors, theoretically this could continue for quite some time, although saturation has taken place in some markets and the number introduced to the scheme who rejected it would be multiples of the 1.8 million figure. Second, there very well be few complaints to the FTC. As we know people are taught to believe they did not succeed due to not working the system. Also, most are introduced to MLM schemes by someone they know and like, people are less likely to file a formal complaint with the FTC against a friend or family member. Why hasn’t the FTC done anything on their own? Perhaps it has something to do with this “Amway founders and top guns have contributed millions to Republican congress members and to President Bush. This was rewarded in 2001 with Pres. Bush’s appointment of Timothy Muris, an attorney that worked for Amway, as chairman of the FTC. Muris has since left the FTC and several key Amway protectors in Congress (e.g. Rich Santorum in PA and Tom Delay in TX) were defeated.” http://www.pyramidschemealert.org/PSAMain/news/MLMInfluenceBuying.html
So to recap, a pyramid could exist for 30 years if it had not yet completely saturated it’s market, if there were few complaints, if the FTC were MLM friendly and the company had political contacts (Johnson admits he is in Washington visiting congressmen and senators monthly). This arguement seems similiar to the arguement from antiquity used by so many alternative medicines… “If accupunture, homeopathy, etc is a scam how could it be around so long”. It can.
Next the article cites “Insider (and Institutional) Ownership” as a defense. Here is the sales history of HLF by Johnson. http://www.insider-monitor.com/trader/cik1311173.html How could this fact, which if fairly well known, be ignored completely by this article? Seems disingenuous to make a case that insiders are buying up the stock and ignore this. As far as institutions owning the company, I refer to my analyst friend who with no knowledge of the business model but loved the financials. There is no doubt pyramid schemes can make an incredible amount of money and look very impressive on paper, but this does not mean the company is not a pyramid scheme per FTC definition.
Next the article again raises the question of three decades of existance and brings up the point that the SEC has already examined them. The SEC examined and questioned their books, as is their role. It is the role of the FTC, not the SEC, to determine if a business is a pyramid scheme. The author should know this. They quote the huge size of the company as if this lends any credibility or indeminifies the scheme of being a pyramid. Pyramid schemes do grow quite a bit prior to saturation and fail.
Under the defense of Herbalife titled “Analyst Defenses, Herbalife’s Financials, and its Valuation” the defense turns bizarre basically making the claim that Ackman is some sort of elitist. What does this have to do with whether or not Herbalife is a pyramid scheme. Are they really that desperate to refer to such an obvious ad hominen attack?
My conclusion is that this article purposefully omitted important material such as the Johnson stock sales, brought up immaterial falacies such as if it is old, it’s got to be legit, and then made an ad hominen attack. No where in the article was the topic of the definition of a pyramid scheme by the FTC or the important topic of sales outside the distributors base brought up. There is no factual statistical defense of the company not being a pyramid.
Lazy Man says
Hmmm, you picked just about the only Seeking Alpha Herbalife article that I haven’t commented extensively on. I’m going to have to catch up on that one.
The SEC shut down ZeekRewards, so they do have the power to shut down pyramid schemes. I always point out that the SEC missed Bernie Madoff for 17 years and he was running a 50 billion dollar scheme.
I have a bunch of words written on Herbalife, but the problem is sorting them into any presentable article that isn’t 5,000 words long.
If you want to talk about bad analysts, see this Business Week article: http://www.businessweek.com/news/2012-12-21/herbalife-bulls-take-on-short-ackman-after-pyramid-claim-retail. These people are paid analysts of Herbalife and they seem to have no clue about MLMs and pyramid schemes. They can’t possibly be objective.