Herbalife: What Have We Learned?

| About: Herbalife Ltd. (HLF)

We learned that each year HLF successfully attracts new distributors and sales leaders. A review of the company's annual 10Ks from 2005-2011, excluding China, shows that beginning with approximately 299K supervisors in December 2004, HLF added over 1.2 million sales leaders (i.e., supervisors) through December 2011. Barring repeats, this brings the potential total to roughly 1.5 million. As of December 31, 2011 HLF reported 501K sales leaders on the books (about 34% of the potential total), though the monthly average of 219K active sales leaders in 2011 suggests a much lower level of involvement (about 15%). [All data referenced in this article come from the following annual reports: 2005, 2006, 2007, 2008, 2009, 2010, 2011, and 2012.]

During the seven-year period, HLF reported annually a number of distributors equal to between 3.5 and 5.0 times the number of sales leaders, with an annual average of approximately 4.2. The number of repeat distributors is not reported though there would likely be some. In past years HLF reported a 90% annual turnover of distributors, though in more recent years the retention of distributors is unreported.

The lack of specificity in HLF's reporting makes estimating the total number of distributors and sales leaders over the seven-year period difficult. The number could be as high as 6+ million. During the same period HLF reported global net sales of $15.46B, equivalent to about $2,500 per distributor/sales leader annually when using 6 million as the worldwide count and $3,100 per distributor/sales leader using 5 million as the worldwide count. We have no reliable information on the amount of purchases made outside the distributor network.

We learned that HLF reports an increasing retention rate. However, in 2004, 2009, 2010, and 2011 HLF altered the criteria for re-qualifying sales leaders. These progressive changes (reviewed below) allowed more distributors to be classified as sales leaders. The 2004 change alone added an additional 10,000 supervisors, not counting 9,000 added due to a change in Russia. Retention stabilized in the low 40% range from 2004-2009, rising over the next three years to 52% in 2012. While retention gains can be viewed as positive, HLF does not report the respective numbers of re-qualified sales leaders according to its many-criteria approach. Are all re-qualified sales leaders the same?

In 2004 - "In order to increase retailing of our products, we have modified our requalification criteria to provide that any distributor that earns at least 4,000 volume points in any 12-month period can requalify as a supervisor and retain a discount of 50% from suggested retail prices, but will forfeit their distributor organization and associated earnings."

In 2009 - "An additional optional qualification, introduced globally in October 2009, allows for a distributor to achieve sales leader level by personally placing orders with Herbalife that accumulate to 5,000 Volume Points within 12 months (of which a minimum of 3 months is required)." Personally placed orders of the required size apparently re-qualify the sales leader with no loss of downline.

In 2010 - "An additional optional qualification, introduced globally in October 2009, allows for a distributor to achieve sales leader level by personally placing orders with Herbalife that accumulate to 5,000 Volume Points within 12 months." No mention of the 3-month requirement described in 2009.

"In order to increase retailing of our products, we have modified our re-qualification criteria to provide that any distributor that earns at least 5,000 volume points in any 12-month period can re-qualify as a sales leader and retain a discount of 50% from suggested retail prices, but will forfeit their distributor organization and associated earnings." The 2004 target of 4,000 volume points increased to 5,000.

In 2011 - "Effective the requalification period ending January 2012, we have further enhanced our re-qualification program for any sales leaders who achieve 10,000 volume points or more within the 12 month period to re-qualify and retain a discount of 50% and their distributor organization and associated earnings."

What does all of this tell us about the possibility of HLF being a pyramid scheme? Not clear. Reliance on recruiting new distributors and sales leaders to generate compensation to participants would seemingly be of interest to the FTC: "The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate
in a money-making venture" (2004 FTC letter). Distributors and sales leaders joining HLF during the past seven years, the vast majority of whom are no longer active, could have been the primary source for generating the net sales and gross profits used to compensate participants, with few sales to non-distributors. Wildly inconsistent statements made by HLF regarding sales to non-distributors have now settled on the favorable numbers reported in the Lieberman study, despite the unreliability of methodology used.

The second reason we are no closer to answering the pyramid scheme question is HLF's apparent lack of concern for enforcing policies consistent with the Amway decision. Indeed, the firm writes: "As a result, there can be no assurance that our distributors will participate in our marketing strategies or plans, accept our introduction of new products, or comply with our distributor policies and procedures" (2011). This is not the legal throwaway sentence where a company says it cannot guarantee that all employees or contractors do what they are supposed to do. No firm can make such a guarantee and HLF also has such a statement: "We cannot ensure that all distributors will comply with applicable legal requirements relating to the advertising, labeling, licensing or distribution of our products" (2011). But the former quote literally says that HLF offers no assurances that its distributors adhere to its policies and procedures - possibly even those rules that prevent a pyramid scheme.

The third reason we are no closer to answering the pyramid scheme question stems from a lack of shared understanding between MLM firms and regulators over what constitutes a pyramid scheme, particularly as it pertains to distributor purchases. The now notorious 2004 FTC letter states, "In fact, the amount of internal consumptions in any multi-level marketing compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme." The sentence does not say that the amount of internal consumption is simply irrelevant to a pyramid scheme analysis. The letter does, however, address the reliance on purchases related to recruitment, "While the sale of goods and services nominally generates all commissions in a system primarily funded by such purchases, in fact, those commissions are funded by purchases made to obtain the right to participate in the scheme. Each individual who profits, therefore, does so primarily from the payments of others who are themselves making payments in order to obtain their own profit."

HLF repeatedly states they sell "through" (not "to") their distributors: "Our products are distributed through a global network marketing organization…" and "Royalty overrides are generally earned based on retail sales…" (2011) and "We discuss retail sales because of its fundamental role in our systems, internal controls and operations, including its role as the basis upon which distributor discounts, royalties and bonuses are awarded" (2012). Yet, at its 2013 Q1 earnings call, HLF shows evident concern with a new "nomenclature project," namely, that the strong majority of its distributors (who either by intent or a failure to succeed) will now be re-classified as "wholesale customers" - thus neither pursuing a business opportunity nor willing to pay the offered retail price.

FTC statements, as recently as those in the FHTM case, highlight the lack of shared understanding and raise two important questions: 1) Why have HLF, its defenders, and others in the MLM industry resisted discussions of sales to non-distributors (i.e., "retail sales") and failed to offer their own view of what constitutes a pyramid scheme (as if not talking about it means it does not exist)? 2) Why over the past nine years has the FTC failed to clarify or amplify for an evolving direct selling industry the meaning of the 2004 letter, particularly as it pertains to internal consumption?

HLF claims compliance with relevant regulations, singling out the Omnitrition decision: "We believe that our network marketing program satisfies the standards set forth in the Omnitrition case and other applicable statutes and case law defining a legal network marketing system, in part based upon significant differences between our marketing system and that described in the Omnitrition case." Yet HLF provides scant empirical evidence of what the claimed "significant differences" may be. The Omnitrition case actually addresses this issue: "A projection or statement of belief contains at least three implicit factual assertions: (1) that the statement is genuinely believed, (2) that there is a reasonable basis for that belief, and (3) that the speaker is not aware of any undisclosed facts tending to seriously undermine the accuracy of the statement." What is the reasonable basis for the HLF assertion that its marketing system is significantly different from Omnitrition's? Would a bit of digging (e.g., company audits for compliance with HLF's retail sales rule, shipping records, etc.) show undisclosed facts that undermine the assertion? We have yet to learn the answer to these questions.

But we have learned that most who pursue the HLF business opportunity will earn little or nothing directly from HLF. Apart from the un-documentable earnings from sales to non-distributors and to other distributors, compensation earned by HLF sales leaders in the US is more skewed than earned income in the US. Of US sales leaders eligible for HLF payments in 2012 (17.6% of all distributors), 31.3% earned $0 and another 47.9% earned $1,000 or less. Just 646 HLF sales leaders, fewer than .74% of those eligible for payments and .13% of all distributors, earned more than $100,000. This small group captured 56% of all compensation from Herbalife. In 2011, the top 20% of US households also earned approximately $100,000 or more and captured 51% of all income. We have yet to learn how HLF distributors actually present such an "income opportunity," only that HLF can offer no assurances that they do so accurately.

HLF and other MLM firms quickly and quite correctly point to the long history of direct selling in providing opportunities for full- and part-time work. However, in single-level direct selling (i.e., no downlines), distributors make commissions on what they sell. In MLM structures like the one used by HLF failure to reach a sales threshold actually makes more margin available to fewer upline participants. In that way an MLM structure can mimic traditional direct selling while simultaneously reducing the costs of recruiting and training a new sales force, and reducing the number of participants who benefit from the selling effort.

Finally, we have learned that the US needs a national pyramid rule. Largely unchallenged interpretations of the FTC 2004 letter drive behaviors that on the surface appear to be similar to those found in pyramid schemes. Perhaps not so amazingly, MLM defenders now argue the irrelevance of past court decisions and the current FHTM case. Yet HLF and others reveal little about their business model and accept no responsibility for the behavior of their independent contractors. To its credit, the SEC has opened an investigation of HLF. As that agency may focus on the underlying premise of a business opportunity, they will hopefully query how the participants succeed within the marketing system and the related importance of sales to non-distributors. A national pyramid rule would clarify and reduce the cost of regulatory enforcement and provide a clear guideline for firms in the direct selling industry.

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.

Additional disclosure: I have no financial position regarding HLF and have received no compensation from any of the parties involved.