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Does Herbalife Violate Anti-Trust Laws? Does Herbalife (HLF) Price Discriminate? This article explores these questions with reference to a prior pyramid scheme enforcement action initiated by the FTC v. Koscot Interplanetary Inc. It strikes me that the parallels between Koscot Interplanetary Inc. and Herbalife are compelling and that Herbalife may be violating Federal Anti-trust laws.

In 1972, the FTC sued Koscot Interplanetary Inc. for Violations of the Federal Trade Act and the Clayton Act and for being a pyramid scheme. Count III of the Violation reads as follows:

COUNT III

Alleging violation of Section 2(A) of the Clayton Act...

PAR. 16. The difference in net cost among the various distributors of respondents' products, each of whom is in competition with other distributors of respondents' products, results in substantial discrimination in the net prices for products sold to the nonfavored customers, who are both direct purchasers and indirect purchasers of respondents' products...

The effect of respondent Koscot Interplanetary, Inc.'s discrimination in net price as alleged herein may be substantially to lessen competition or tend to create a monopoly in the line of commerce in which its favored purchaser is engaged, or to injure, destroy, or prevent competition between the favored and nonfavored purchasers or with the customers of either of them...

The aforesaid acts and practices of respondents constitute violations of the provisions of Section 2 of the Clayton Act as amended.

In the judgment issued in 1975, the following was written:

III. Restraints of Trade

B. Price Discrimination

145. The facts as to the price discrimination charge (complaint, Count III) may be briefly stated.

Koscot discriminated in price between competing purchasers of its products. To distributors Koscot sold at 65 percent off the retail price, while to supervisors or subdistributors (hereinafter 'subdistributors') it sold at 55 percent off retail price. [FN25] (P36, supra) Since both distributors and subdistributors sold to beauty advisors at 40 percent off the retail price, the distributor's gross margin on such sales was 25 percent, while that of a subdistributor on such sales was 15 percent. On direct sales to consumers, distributors enjoyed a gross margin 10 percentage points above that of subdistributors.

(B) The products involved were of like grade and quality.

(C) Distributors and subdistributors performed the same function in the sale and distribution of Koscot products. Both classes of customers purchased directly from Koscot and resold to consumers, either directly or through beauty advisors.

(D) There was competition between distributors and subdistributors, not only in direct sales to consumers, but also in the recruitment of beauty advisors and in sales to beauty advisors.

(E) There is evidence of actual or potential injury to competition as a result of the discriminations. Irrespective of such evidence, however, the magnitude of the discrimination was such as to warrant an inference that the effect may be to substantially lessen competition.

(F) There was no showing by Koscot that the price discriminations were justified on any of the grounds specified by the applicable statute (CPF 494­ 508).

146. Accordingly, such discriminations in price were in violation of Section 2 of the Clayton Act, as amended.

____________________

Herbalife's compensation system clearly does not treat all distributors equally. Non-Sales Leaders receive a 25% discount on merchandise. Sales Leaders receive a 50% discount on merchandise. This has the following implications:

1) Sales leaders can effectively price Non-Sales Leaders out of the retail market. Take a simple example.

  • Distributor A (Sales Leader) buys $50 worth of product and pays $11 Shipping and Handling for a Net Cost of $61.
  • Distributor B (Non-Sales Leader) buys the same amount of product for $75 plus $11 Shipping and Handling for a Net Cost of $86.
  • Distributor A can sell product to an end customers for $85, capture 41% gross margin points and still guarantee that Distributor B would lose money on the same transaction. $85-$86 = -$1.

2) Compensation benefits in the incentive system accrue to those higher-up in the Herbalife pyramid. Not only do Sales Leaders buy the product for less money than downline distributors, they also receive additional Royalty Overrides on all product purchased by downline distributors. Theoretically, these Royalty Overrides could also be reinvested in pricing to make Sales Leaders even more competitive when selling to actual Retail Customers (if there are any).

3) Requiring Non-Sales Leaders to pay 50% more net of Shipping and Handling fees for the same product effectively guarantees that these distributors must fail as retailers in the marketplace.

Why?

Because the market clearing price for most inventory will be lower than their Cost of Goods. We see direct evidence of this reality on eBay. The company also tells us that distributors who buy for personal consumption typically buy for 25% off from upline Sales Leaders.

This may help drive company sales, but it cannot enhance the business prospects of a new distributor who actually intends to become a legitimate reseller of the product and who relies upon Herbalife's representations in recruiting materials.

Query:

1) What is the business purpose behind charging distributors different prices for the same exact product?

It would seem, on the face of it, that the purpose of the price discrimination is 3 fold.

  • To encourage recruiting by Sales Leaders. Because Sales Leaders can make an extra 50% on all sales made to or by downline distributors, the additional margin points encourage recruitment of both new distributors and end-customers into the Sales Leader's downline.
  • To protect the earnings of upline Sales Leaders at the direct expense of downline recruits who must x-subsidize their upline brethren by paying more for product while sending wholesale commissions and royalty overrides up the chain.
  • To encourage downline distributors to purchase more product. The incentive system upgrades the discount a distributor receives as they purchase more product and earn more Volume Points. However, there is no requirement that these purchases are tied to actual retail sales outside the network. Practically, low-level distributors can "buy their discount".

Query:

2) How does Herbalife's price discrimination encourage "outside sales" to arm's length retail customers at suggested retail price?

The only logical answer to this question is: "It doesn't, because it can't."

If Herbalife wanted to treat all distributors equitably and to give all distributors an equal opportunity to be successful reselling Herbalife product, each distributor would be able to purchase the product for the exact same price. Instead, Herbalife discriminates against one segment of its salesforce to the specific benefit of the Sales Leaders who sit upline in the hierarchy.

This policy also has the effect of poisoning the pricing power in the end-market for Herbalife product by lowering the market-clearing price at or below a Non-Sales Leaders COGS.

Based upon the Trial Judge's ruling in the Koscot case, this would appear to be, facially, an obvious violation of Federal Anti-Trust law.

Intuitively, Herbalife's compensation system offers a compensation monopoly to those distributors who get into the scheme early or who sit upline in the pyramid. These distributors can use their monopoly pricing power to effectively price new distributors out of the marketplace.

Do we have any evidence that this is actually occurring?

1) Herbalife tells us that the majority of Non-Sales Leaders churn out of the business in less than a year. Concurrently, Sales Leaders turn over at around 50% per annum, while those who are Team Leader or above barely turn over at all. Common sense tells us that it is the money losers who turn over while those who make money from the churn lower down remain.

2) The evidence communicated by the company, distributors in the marketplace, online pricing surveys (see eBay) also suggests that the market clearing price for Herbalife product is much lower than the suggested retail price that appears on the invoices sent to distributors with each shipment. More importantly, the market clearing price of Herbalife product makes it impossible for a new Herbalife distributor to make a retail profit at that price when Shipping and Handling fees and sales taxes are loaded on top.

To summarize, Federal Anti-Trust law seeks to protect market participants from practices that are anti-competitive or may lead to monopoly.

Herbalife's incentive system clearly does not treat all distributors equally. Economic laws of supply and demand and price elasticity function to conspire against Non-Sales Leaders while all monetary rewards in the system accrue to those who enjoy the right to purchase product for 50% off SRP and receive royalty overrides to boot.

Whether or not Sales Leaders buy product from Herbalife for personal consumption, to resell the product to other distributors or to resell the product to "outside retail customers", they have a monopolistic advantage guaranteed by Herbalife itself vs. their down-line competitors. The incentive system bakes these outcomes into the cake.

Applying the logic in the Koscot case, this would seem to be a violation of anti-trust law. More importantly, it may also be another indication that Herbalife is, in practice, a pyramid scheme. De minimus, it just seems downright unfair and begs the obvious questions:

Why would anyone, today, want to become an Herbalife distributor other than to get a 25% discount for personal consumption? Who, if anyone is paying SRP for Formula 1?

Source: Does Herbalife Violate Anti-Trust Laws?