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After many online posts, including my two on Seeking Alpha here and here, a shared understanding of what constitutes pyramid scheme behavior somehow continues to elude concerned investors. A case in point is a recent post by Jon Hempton claiming to "test" Herbalife (NYSE:HLF) against his understanding of a pyramid scheme.

Let's first do away with the non-issue - a pyramid scheme charge is not about product efficacy. If used as directed Herbalife products probably work, as have the products of many MLMs found to be pyramid schemes.

Let's next look at his simplistic, erroneous pyramid scheme definition: "In summary: real sales to consumers is kosher. Sales to distributors (and not to end consumers) are not kosher. A little of the latter is OK (the distributors do need to have some stock). A lot of the latter is not." Where in this definition does he include the issue of reliance on recruitment, distributor turnover or churn? Why, throughout his analysis, is this ignored?

Let's look at his second attempt to offer a pyramid scheme definition: And this is the critical question. "If the single level distributors are distributors without end sales then this is a pyramid. If the single level distributors are really consumers then this is not a pyramid, is legal and probably sustainable." These two sentences misrepresent what constitutes a pyramid scheme. If a single level distributor is a distributor without end sales, then they are a distributor without end sales. That does not per se make any MLM a pyramid scheme and the FTC accounts for buying clubs in footnote #2 of the 2004 Staff Advisory. What he attempts to show with these two sentences is that it depends on how you look at it - suggesting that you can consider single level distributor without end sales to be "a pyramid" or you can consider single level distributors as consumers and, hence, "legal and probably sustainable."

There will be distributors without "end sales" and distributors certainly will buy products to consume. The courts have been very clear that a pyramid scheme analysis focuses on sales to non-distributors relative to sales to distributors in the presence of ongoing recruitment (see: FTC vs. Koscot, FTC, et al., vs. Equinox, Webster vs. Omnitrition, FTC vs. BurnLounge, and FTC, et al., vs. FHTM, among others). Sales to distributors for their own consumption (i.e., internal consumption) is part of any MLM. But, as in FHTM, the FTC looks for the volume of sales to non-distributors and the extent to which such sales could finance the rewards paid upline for new recruits and (inseparably) their related purchases to set up the business venture. Hempton references no court decisions that address this issue. Instead he rewrites what he thinks the issues to be, completely ignoring court decisions and, again, completely ignoring the issue of recruitment.

Finally, his straw man is that we should see massive amounts of inventory, which of course we have seen in some pyramid schemes. The absence of massive amounts of inventory, however, does not mean with any certainty whatsoever that Herbalife is not a pyramid scheme. As noted in the federal court's decision in BurnLounge, inventory loading is not a necessary element of a pyramid scheme.

In MLMs found to be pyramid schemes compensation to participants relied on ongoing recruitment. A major defense against the charge has been evidence of substantial retail sales and no inventory loading, but the key is compensation to participants reliant on recruitment, which he conveniently ignores. Let's say we have three kinds of distributors:

1) new distributors buying for their own consumption and selling some to non-distributors;

2) ongoing distributors (in Herbalife this may be as few as .50 x .17 and .10 x .83 = .168 each year, where .5 and .1 are the respective retention rates for sales leaders and non-sales leader distributors) also buying for their own consumption and selling some to non-distributors; and,

3) former distributors - people who tried and quickly became inactive.

First, Herbalife's own retention figures (the .5 from current annual reports, the .1 from 2005, the last time reported) raises serious questions regarding distributor retention. Here is what could be happening and is completely consistent with Hempton's evidence: Each year Herbalife recruits a large number of distributors because 90% of last year's non-sales leader distributors quickly became inactive as did 50% of last year's sales leaders. Newly recruited distributors buy products, and some successfully sell products to non-distributors. They soon question the "business opportunity" and become inactive as do their non-distributor customers. Therefore we do not see a build up of inventory. The only "stability" we see is with some number of retained sales leaders. If the products are so wonderful, where are sales to former distributors? The convenient answer is that they either lost weight without need for any continued use of the product or they stopped trying to lose weight. The inconvenient answer could be that they bought into a "business opportunity" that was not what it was portrayed to be. We know this is at least possible given the recent exposés of certain Herbalife distributors here and here. There may be some inventory build up in a percentage of retained sales leaders trying to maintain their eligibility but not in the large percentage of distributors.

One last point, Hempton mentions Herbalife's "superior gross margins." My scenario above explains the truly out-sized gross profits of 80%, year after year. Briefly, new distributors are initially willing to pay the substantial price for these products because the price implicitly includes the right to receive rewards for building a downline. For those whose downlines fail to materialize (the vast majority of new recruits who experience no real business opportunity), they just stop paying this high price by dropping out.

His scenario does not explain the out-sized profit margin. If this was simply a case of a successful consumer product with "superior" gross profit then why do we not see more of this in other firms? Where are they? One thing I found in talking recently with so many people in finance is the abundance of well-educated folks - MBAs from Wharton, Harvard, Columbia, etc. Not one, literally not one, has been able to explain to me what in their business education or experience explains Herbalife's consistent ability to produce 80% gross profit in their product category. In a recent meeting in NYC I asked investors what the CEO of P&G would say if they asked him what it would take to move P&G's usual 50% gross profit to 80%. One bright young man quickly said "It's not going to happen" and he is quite correct.

Rather than read observations of yet another investor, we will do better by focusing on the publicly available lessons regarding pyramid schemes consistently articulated via a series of FTC and federal court decisions.

Source: Hempton's Failed 'Test' Of Herbalife And Still Unanswered Questions

Additional disclosure: I have received no compensation from any parties associated with the Herbalife controversy. I choose not to post anonymously and encourage you to do the same.