Tomorrow, the FTC will be conducting a press conference to reveal a crackdown on deceptive advertising for Weightloss products. Evidently, regulators are actively monitoring this space for illegal and fraudulent conduct. This seems like an appropriate time to remind investors that Herbalife (NYSE:HLF) is, itself a deceptive marketer that needs to be shut down by regulators.
Specifically, investors who are new to Herbalife should beware of the following. Herbalife is the sponsor of a marketing plan that functions as a pyramid scheme. Every single day the company continues to operate new "Members" are actively recruited to pursue a business opportunity that simply does not exist because the world is already saturated with existing Herbalife distributors.
Here's how it works.
New recruits are taken to opportunity meetings by recruiters. These controlled settings set the stage for the indoctrination into the Herbalife scheme.
Here is what Mark Hughes has to say about "opportunity meetings".
Does group psychology work? Watch this video featuring the Asch experiment in action and judge for yourself. Herbalifer's know the power of group dynamics on conformity. That is why most Herbalife indoctrination occurs in group settings.
Once new recruits have been bamboozled with testimonials and exaggerated product and earnings claims, the Herbalife cycle starts with a simple transaction. New members purchase an IBP to join the Membership. Details on the IBP can be found here. This Initiation fee transaction starts the clock.
On the one year anniversary date of the IBP registration the Herbalife member must pay a renewal fee.
How much is the renewal fee?
$10. A measly $10 if you are not a Supervisor. $59.95 if you are a SUPERVISOR.
Taken from a Herbalife website, here is how it works:
Q: Why do I have to pay an annual Processing Fee?
A: The fee allows you to maintain your Distributor status. If it is not paid then your Distributorship is subject to deletion.
Q: When is the payment due?
A: Your annual Processing Fee is due once each year on the anniversary of your signing your Distributor Application Form.
Q: What if I forget to pay?
A: Herbalife tries to send out reminders to each Distributor, however, to be certain, you really need to be aware of the date and write it in your Herbalife Journal. If you have any concerns, just call us and we will advise you of your renewal date.
Q: How much do I pay?
A: Only $59.95 for Supervisors and $10.00 if you are a Distributor/Senior Consultant.
Q: How can I pay?
A: It's easy! Simply complete the reminder slip we send to you. Or, you can pay in the same way as you would pay for a product order: with credit card, wire transfer or cash (cash payments can only be accepted for walk-in-orders at the warehouse).
Costco has an annual membership fee. So, too, does GNC. 90% of Costco members renew. Roughly 70% of GNC members renew.
Herbalife tells us they have the cure to the global obesity epidemic and the solution for these tough economic times.
Q. What % of Members would you expect to renew against that kind of backdrop?
Would it surprise you to learn that over 80% of Members and 50% of Sales Leaders/Recruiters choose not to pay the annual processing fee on the 1 year anniversary of their initiation?
Does this strike you as the kind of behavior one would expect from the customers of a company that sells a truly effective product and a highly compelling and profitable business opportunity?
Or, is something else going on?
Herbalife is a very opaque enterprise. The company's CFO is a crafty fellow. Herbalife reveals lots of data in its 10Ks and 10Qs and yet as analysts we always seem to have to solve for X to uncover the variables that would serve as evidence that Herbalife is a pyramid scheme.
What do I mean by this?
A simple algebra equation might be:
6 = x/3
Solving for X we rearrange the equation to get.
3 x 6 = X
So, X = 18
Herbalife often gives us data points to consider and yet conveniently leaves out the X variable whenever X = Trouble.
Here are some examples:
- Herbalife tells us how many new Members it recruits each quarter. Herbalife also tells us how many distributors it has at the end of each quarter. Herbalife fails to disclose how many distributors resign each quarter. To answer this question we must solve for X.
- Herbalife tells us how much product they sell to their wholesale distributors. Herbalife gives us a fictitious estimate of its Distributor Allowances/profit centre for wholesalers. Herbalife does not disclose how much product is actually sold to real retail customers. To guesstimate this data point we must solve for X.
- Herbalife classifies its non-Sales Leaders as Members and tells us that Members join-up as "personal consumers". Herbalife calls its Supervisors Sales Leaders and tells us that Sales Leaders purchase most of the product the company sells at wholesale. Yet, Herbalife does not tell us how many Members are striving to become Supervisors nor how much of total company sales is ordered by Sales Leaders v. Members. Again, to guesstimate these data points we must, as analysts, try to solve for X.
- Herbalife tells us how much revenue they generate from Shipping and Handling. Herbalife does not, voluntarily, disclose the costs of this program. Solving for X due to an SEC inquiry we now know that this is a huge profit center for the company that it has historically tried to hide from its business partners.
Solving for X also helps us to understand the Herbalife Distributor Cycle.
We know, categorically, that Herbalife successfully recruits hundreds of thousands of new people per quarter around the world. Remember, Herbalife is a recruiting company and recruiting is what it does best having honed its deceptive message with years of practice. We also know that most of these people fail to renew their Memberships on the one year anniversary date of their initiation.
Solving for X we can conclude that something goes terribly wrong for these people in the interim.
If it did not, we might expect renewal rates to rival Costco or GNC.
Q. What could possibly be going wrong? Let's explore our options as we try to solve for X.
Option 1 - Members simply don't like the products. Seems to me, if Members liked the products then they would keep buying them. eg. I purchased my first Coca-Cola at the age of 11. I am 44 and still drink it to this day. Why? I like the product. Herbalife tells us that people love their product so much they are willing to buy an IBP to get a discount. Herbalifers also tells us that "personal consumers" are willing to pay a premium price because they love their Herbalife coaches.
Q. If Members invested $50 - $100 to secure a 25% discount on product they like and enjoy sold by a nutrition coach they love and enjoy a measly $10 renewal fee seems like a small price to pay to preserve said discount and relationship. No?
If Formula 1 was a delicious and tasty meal replacement worthy of daily consumption people would consume it every day in perpetuity. Instead, most people resign. Why? Option 1 - people simply don't like the products, or their sales rep, or both.
Option 2 - Members actually love the product. This is what Herbalife trolls (Herbalifers)tell me repeatedly on the chat boards. Supposedly, in practice, Members love the product so much that they consume it in droves. In fact, Formula 1 is such a great product and so successful that Members use it, hit their weight loss goals and then (wait for it) quit forever. To repeat: so satisfied with the product's performance people love it so much that they stop using it altogether. (I call this kind of argument Herbalspeak)
I am also told that people love the product so much that they quit and return later on for another go round. Curiously, these Herbalife evangelists prefer to resign, wait a year and then re-up their $59 to get a 25% discount v. simply paying a measly $10 renewal fee to preserve their membership status. So, again, Option 2 - customers love the product so much that they quit - then comeback - then quit again, etc.
Option 3 - Members fail at the business opportunity. New Members, having purchased their IBP, then invest in an inventory load in advance of an effort to retail and/or recruit.
Q. How much inventory do they load?
A. It depends. It depends upon which Membership their recruiter wants them to buy. For sure, recruiters get paid the most when their recruits buy a SUPERVISORSHIP. $3k of inventory is the ticket that must be punched to get a 50% discount on purchases, max wholesale commissions, max retail margins and the chance to earn royalty overrides on downline purchases.
Make no mistake, SUPERVISORSHIPS are the Platinum level membership for a new recruit and the recruiter. But, not to worry, if you can't get there straight away you can whittle away at it by starting as a SUCCESS BUILDER and then "Buying Your Way" up to the SUPERVISORSHIP over time. Sounds exciting, yes? All you have to do is simply "pay to play". Easy right?
If so, why do so many Members quit soon after they embark on the road to SUPERVISOR?
Could it possibly be that Herbalife's end markets are already saturated with distributors?
Could it be that websites like Herbalwell.com already flood the retail market with heavily discounted product so there are no retail profits to be had?
Could it be that there are not enough people with $1,000 - $3,000 to invest left to recruit to build a downline?
Could it be that Mexico already has enough Nutrition Clubs?
Could it be that people who try the product simply don't like it for long?
Could it be that Herbalife distributors are the marketers of a pyramid scheme?
Could it be that Herbalife sponsors an endless chain of new recruits?
Solving for X what does common sense tell you?
The Herbalife life-cycle is simple to describe for the typical recruit who now enters the pay plan in the later innings.
DEATH OF A SALESMAN is the inevitable outcome.
How do we know?
We know that lots of people sign-up.
We know that lots of inventory gets bought.
We know that most people do not renew their Memberships on their one-year anniversary.
Solving for X as to why that is the case, the only rational conclusion one can reach is that Members do not get value for their initial investment and so they quit. The dream they are sold turns into a nightmare.
The false and deceptive promises laid out in the opportunity meeting fail to come true. Instead, these unwitting recruits are victimized by a rigged game. Most cut their losses and move on.
What does the SEC have to say about "opportunity meetings"?
It further appears to the commission that the pyramid sales promotions that are often employed in connection with the sale of securities of the types de scribed above may be Inherently fraudulent. Under these programs, various cash fees and percentage incentives· are offered to those willing to participate as an Inducement for the recruitment of additional participants. This aspect of the promotion is often given great emphasis at "opportunity meetings" at which movies may be shown and speeches made concentrating on the allegedly unlimited ·potential to make money in a relatively short period of time by recruiting others into the program. Since there are a finite number of prospective participants in any area, however, those induced to participate at later stages have little or no opportunity for recruitment ... In the Commission's view; use of this inherently fraudulent device to induce investment in any enterprise offering securities to the public is a violation of the antifraud provisions of the securities laws.
Make no mistake if you are long. Herbalife is a global pyramid scheme that will be shut down by regulators. It is only a matter of time.
Solving for X, Herbalife is an endless chain that recruits prospects into saturated markets. Economic losses are baked in the cake.
Tomorrow the FTC will tell us about a crackdown on false advertising claims. Can a pyramid scheme prosecution be far behind?
Disclosure: I am short HLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.