Ackman Was Too Kind In His Attack On Herbalife

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By Jon M. Taylor :

With the hedge fund battle initiated by Bill Ackman's December 20 Sohn Conference presentation - calling Herbalife ( HLF ) a "pyramid scheme" - one point has been overlooked. He was way too kind in his criticisms of the company and of the multi-level marketing (( MLM )) industry, of which Herbalife is a top player.

As a consumer advocate with four decades of teaching, writing, entrepreneurship, and consulting related to the field of home business opportunities, I have analyzed approximately 500 MLMs (multi-level marketing programs) over the past 18 years and written three books on the subject. I would have to rank Herbalife near the top of the list of questionable MLMs.

Ackman concluded his presentation by charging that 1.9 million Sales Leaders for Herbalife have lost $3.8 billion since the company's founding in 1980. In my opinion, this is a gross underestimate. Let's look more closely at the numbers.

Calculating the harm done by Herbalife

I agree with Ackman that the products are too expensive to be competitive with retail alternatives and that little selling occurs to persons who are not participating in the program. And no one makes the "residual income" held out to prospects without building a sizable downline of distributors beneath them. Careful study of the compensation plan confirms this. And why would anyone attempt to sell overpriced products, when they can be bought much cheaper online and when the plan offers huge rewards for recruiting, compared to a pittance for selling direct to non-participants?

To build a downline is expensive and getting more so, as hundreds of MLMs are saturating U.S. and overseas markets. So Herbalife must "re-pyramid" (rebuild new pyramids) into market after market to compensate for what Ackman calls the "pop and drop" phenomenon, as each market reaches saturation and impending collapse - with no sustainable retail base of non-participating customers. The company's entries into obscure markets does not represent real growth, but merely re-pyramiding to replace declining markets for its bogus "income opportunity." Herbalife's nutrition clubs and ubiquitous "work from home" ads are merely efforts to maintain its income stream by recruiting a revolving door of new recruits, each investing their hard-earned dollars before giving up.

Ackman cites evidence that the cost of becoming a Sales Leader is at least $10,000, and my own one-year test of a similar program (Nu Skin) suggests that the cost of conducting a successful MLM recruitment campaign is actually much more. A review of Herbalife's "Statement of Average Gross Compensation of U.S. Supervisors - 2011" shows that only 3.5% of "Total Leaders" are paid commissions exceeding $10,000, making it possible for them to realize a net profit after expenses. These are at earnings levels labeled "Get Team," Millionaire Team," and "President's Team."

The Statement claims that 25% of Distributors reach the level of "Supervisor" and above ("Leader"). Dropouts are not counted in its statistics, which hugely skews the calculations of average incomes to appear to suggest a far more favorable success rate. The company also claims that it has improved its retention rate, bringing it from approximately 43% to 48.9% in 2011. If we (1) assume a 50% dropout rate, (2) include the 75% of distributors who did not reach Leader status, (3) project the 50% dropout rate over a ten-year period, and (4) subtract costs of recruiting a downline, we get a loss rate of approximately 99.88%. In other words, about one distributor out of 813 realizes a significant profit after expenses. And if we exclude those few who hold the top spots in the pyramid of distributors (which also hugely skews the averages), the odds of new distributors earning significant profits is less than one in 10,000 - essentially zero. Recruits are being sold a ticket on a flight that has already left the ground.

Now let's look at the number of Herbalife distributors that have been recruited (and victimized) since the company's founding in 1980. By 1996, the company reported sales of $1 billion, and by 2011, it reported 3.15 million distributors selling a total of $4.3 billion. If we conservatively estimate an average of at least one million distributors and average sales of at least $1 billion per year since 1980 (allowing for a minimal amount of sales to non-distributors), the total number of distributors cycled through the program during those 32 years would be roughly 32 million, with a total of about $32 billion in sales. Since 99.88% lose money, the total recorded as sales for the company could be considered an estimate of the losses for the downline distributors who provide the vast majority of the company's revenue from their failed investments. This is roughly eight times the losses reported by Ackman.

NOTE: My methodology and calculations were validated by five financial experts, but readers can examine this for themselves by reading chapter 7 of my free eBook The Case (for and) Against Multi-Level Marketing .

So what is a pyramid scheme - and are all MLMs pyramid schemes?

Ask ten regulators (from the FTC, SEC, and state AG offices) to define a pyramid scheme, and you get ten different answers. About the only thing they (and Ackman) agree upon is that if revenues are derived primarily from recruitment, rather than from product sales, it's a pyramid. But even then, some would say that most sales must be to non-participants, while others would not even make that distinction. In fact, it is hard to get agreement on a good definition of "multi-level marketing."

The problem with most pyramid definitions is that they focus on beha vioral characteristics , rather than on the underlying structure of the scheme. Ackman posits six "indicia of pyramids" - all behavioral:

  • Exaggerated earnings claims
  • Inflated prices and need to sell to other members
  • Emotional sales pitch - the "Dream"
  • A history of lawsuits
  • Targeting the financially unsophisticated
  • Complex compensation plans

Note that none of these addresses the fundamental structural flaws in all MLM programs. Let me try to summarize an entire chapter in my eBook in which I define what is and what is not MLM and on what constitutes a pyramid scheme.

To gain a good grasp of this definitional issue, one can benefit from looking at the features of a classic, 1-2-4-8 no-product pyramid scheme, such as the "Airplane Game," which was active in the late 1980s. The nomenclature of the various levels of the game involve participatory levels such as 'passenger', 'flight attendant', 'co-pilot' and at the top, 'pilot'. Typically, a new recruit would pay $1,000 to enter at the level of passenger, in the hopes of receiving a $14,000 payout when one 'piloted out' at the top of the scheme. When the downline of 14 participants have each paid their money to the pilot at the top, the pyramid matures and the pilot departs with his booty, allowing the next person to move up to his spot and those at the bottom to continue the recruiting process in hopes of each reaching the top and receiving the cash reward. Because of the endless chain of recruitment, the pyramid ultimately saturates a given market, and those at the bottom levels (93.3% of participants) are caught in a losing position. The loss rate of participants averages about 90% (between 87.7% and 93.3%, depending on the percentage of pilots who have continued to initiate new pyramids after reaping the reward).

The fundamental flaw in all pyramid schemes is the assumption of an infinite market, since they are structurally built up on an endless chain of recruitment. It is assumed that they will inevitably reach market saturation and collapse. The only way to get to the top is to recruit others into the scheme. There is a requirement for an investment ("pay to play") in order to participate. And all the money goes to the top.

MLMs, which evolved from classic, no-product pyramid schemes (and chain letters) are what I call "product-based pyramid schemes." They operate structurally on exactly the same principle, except that they disguise or launder the investment in the pyramid with the purchase of products (usually "pills, potions, and lotions"), and the pyramid may be many more levels deep, as with Herbalife. Typically, they spread rapidly through recruitment of a whole network of endless chains of participants (a.k.a., distributors, associates, agents, etc), with thousands, or even millions of participants in an ever expanding mega-pyramid of participants. And instead of a loss rate of approximately 90% as with classic 1-2-4-8 pyramid schemes, the loss rate for MLMs is closer to 99.9%. So participants in a classic, no-product pyramid scheme are 100 times more likely to profit as are participants in a product-based pyramid scheme. And in fact the likelihood of receiving the promised rewards by getting to the top of a classic, no-product scheme are at least 1,000 times as great as in a product-based scheme/MLM.

MLMs are not even shaped like a classic 1-2-4-8 pyramid scheme - which is so named because it looks like pyramid scheme with one, then two, then four, then eight participants stacked atop each other in the four levels of the pyramid. But most MLMs have far more levels, and by the time a 6th or 7th level in an MLM is reached, the number of participants is extremely wide, making the structure look more like a pancake (with a bump in the middle for the "upline") than a pyramid. An MLM like Herbalife could more appropriately be called a "pancake scheme," with a much larger base at the bottom losing money.

So I conclude that Ackman's claim that Herbalife is a pyramid scheme is an extreme understatement - way too kind. My research convinces me that MLMs like Herbalife are a form of white collar crime that is far more damaging than are classic no-product pyramid schemes, by any measure - loss rate, aggregate losses, or number of victims.

As a flawed business model, MLM is unfair, deceptive, viral, and predatory

As if Herbalife by itself did not do enough harm to consumers struggling to stay afloat, it should be noted that Herbalife is one of hundreds of similar MLM programs with a loss rate I calculate to be upwards of 99%, several of which are publicly traded - Nu Skin ( NUS ), Medifast ( MED ), PrePaid Legal (PPD), USANA ( USNA ), Mannatech (MTEX),Tupperware (TUP) etc.). In the aggregate, tens of millions of MLM victims worldwide suffer losses of tens of billions of dollars every year.

In my opinion, Ackman errs in suggesting that Herbalife stands out as a "bad MLM," choosing to compare it to Avon. While it is true that Avon was once a legitimate direct selling company, they recently changed their program and are much more recruitment-driven, like other MLMs. I will grant that some MLMs like Herbalife and Nu Skin are worse than others, in that they are more highly leveraged; i.e., leveraging the losses of a huge downline of participants (victims) to the benefit of a few at the top of the pyramid. Looking at the industry as a whole, there are hundreds of MLMs with compensation plans (the root of all the problems) that are built on the same flawed assumptions that drive Herbalife.

Of approximately 500 MLMs I have analyzed, ALL assume an infinite market, which does not exist in the real world. ALL assume a virgin market, which does not exist for long. ALL suspend the laws of supply and demand, rewarding unlimited recruitment of a whole network of endless chains of participants - who are the primary customers. ALL hold out a false hope of income that is only possible for those at or near the top, who are usually the first ones in. And I have identified over 110 typical misrepresentations that are used in MLM recruitment campaigns. In fact, ALL of the MLMs I have studied are extremely unfair and deceptive and (as endless chain "opportunity" recruitment schemes) both viral and predatory as well.

Ackman is right in concluding that society would be better off without Herbalife. But Herbalife could be included in a multitude of MLMs that sap the most vulnerable among us of much-needed resources, and I would argue that that society would be far better off without all MLMs that follow the same endless chain recruitment model.

Most MLM recruits spend a few hundred dollars but find the selling of overpriced products and the pressure to recruit too formidable, so they drop out. They are the lucky ones. Others believe the MLM hype and become more committed, spending the family fortune or going deep in debt. Prospective MLM recruits should be given the warning: "the more you spend, the more you lose" - which is true of any scam.

Don't join Herbalife - gamble!

Let's look at it another way. Using the calculations above, you are 24 times more likely to profit from a single bet on snake eyes in a roll of the dice in a game of Craps in Las Vegas as you are to profit as a Distributor for Herbalife. And this is without risking one's social capital - the friends and family that resent your efforts to recruit them and may even shun you as loved-one-turned-recruiter.

It should also be noted that the personal losses from MLM participation often far exceed financial losses. From reports we have received, I conclude there are many thousands of divorces, estranged extended families, bankruptcies, lost homes, diverted careers, and even suicides. Some become addicted to the "easy money" allure of MLM to the point that they can no longer work at an honest job, but keep moving from one MLM to another in hopes of finding "the right program" for them. We refer to these victims as "MLM junkies."

So where is law enforcement in all this?

The Federal Trade Commission is supposedly the nation's consumer watchdog, charged with protecting consumers against "unfair and deceptive acts or practices in the marketplace." (Section 5 of the FTC Act.) Unfortunately, investigators working for the agency have assumed that any pyramid will reach saturation and collapse. They also assume that if MLM fraud was widespread, it would be reflected in a large number of complaints. They are wrong on both counts.

Let's look at the first issue. The assumption that pyramid schemes ultimately lead to saturation and collapse misled prosecutors involved in the 1979 FTC v. Amway case. Amway attorneys argued that though the company had been active for 20 years, it had not even captured 1% of the market - far from a saturated market - and therefore was not a pyramid scheme (assuming certain "retail rules" were enforced). But no distinction was made between total saturation and market saturation . Why would a city of 100,000 people need 100,000 distributors? Five may be plenty, with each new distributor finding it more difficult to get customers. So total saturation is absurd. It is market saturation that is at issue, and that happens very quickly. No MLM market can sustain itself, since there is no significant base of actual customers who are not participating in the scheme. MLMs like Herbalife get around this problem by "re-pyramiding" into new markets and/or by introducing new products and programs. Ackman's presentation of the "pop-and-drop" syndrome in one country after another demonstrated the need for such aggressive re-pyramiding in order to survive and grow.

And why do victims remain silent?

This is one of the most insidious facets of the MLM problem. Even MLM victims who have lost thousands of dollars almost never file complaints with either state or federal authorities. They blame themselves for their "failure" since MLM promoters claim that their programs are perfectly legitimate and that success is assured for those who work hard. But worldwide feedback from victims and their families convinces me that a greater factor for the silence of victims is fear . Since all MLMs are endless chains, every major victim is of necessity a perpetrator, having recruited as many people as they could in hopes of covering their expenses and eventually profiting. They fear self-incrimination, and they fear consequences from or to those they recruited, which likely includes close family and friends. So they remain silent. And since in law enforcement, the squeaky wheel gets the grease, nothing gets done.

Of course, one could complain to the Better Business Bureau. But the BBB includes among its "corporate sponsors" some leading MLM companies. In fact, the BBB gives an A+ rating to Amway - which says more about the BBB than it says about Amway.

The FTC caves to the DSA/MLM lobby

In 2006, the FTC proposed a "Business Opportunity Rule" which would have required that business opportunity sellers disclose average incomes, any legal actions against the company, refund provisions, a list of references, and that a 7-day waiting period be required before investing in the program. The Direct Selling Association ((DSA)), the lobby for the MLM industry, appealed to millions of MLM participants and got over 15,000 MLM participants and 84 congressmen (influenced by money and votes) to write in and complain that MLM (re-branded "direct selling") be exempted. The FTC officials caved and exempted MLMs from compliance! What is needed to tackle the MLM issue are a cadre of Eliot Spitzer-style regulators, with the skill and the will and the resources to stand up to the DSA/MLM lobby (a.k.a. "the pyramid lobby").

The influence of the powerful DSA/MLM lobby over the FTC is detailed in a 200-page report I just completed titled: REGULATORY CAPTURE: The FTC's Flawed Business Opportunity Rule, which can also be downloaded free of charge from my web site.

Conclusion

Where Ackman's short attack on Herbalife will wind up, no one knows. But I do know this. Daniel Loeb, Carl Icahn, and others who are betting long on the stock either don't understand the business model, or they don't care that millions of struggling families are impoverished by its tentacles, and our society is worse for allowing such unfair and deceptive practices to sap our resources and corrupt our markets. Bernie Madoff was a stain on Wall Street and the SEC. MLMs like Herbalife are a stain on Main Street and the FTC.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

See also Two Harbors Is Likely To Cut Its 2013 Dividend on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: HLF , MED , MLM , NUS , USNA

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