One of the more popular songs burning up the airwaves right now is a dance song called #Selfie, written by The Chainsmokers. If you have 3 minutes and 44 seconds of your life that you are willing to give away forever, you can watch the music video here. The video and lyrics clearly poke fun at the degree to which human beings become self-absorbed and take pictures of themselves with their gadgets, affectionately known as "Selfies".
Herbalife (NYSE:HLF) launched a PR website at iamherbalife.com this week. Included on the website is a database of "Selfies". The purpose of the database is simple. Herbalife wants the world to see that there are real people who really consume Formula 1 shake mix and who love the product.
How about a database of profitable distributors?
The question for investors long and short is, does this kind of evidence protect Herbalife from a pyramid scheme prosecution?
In this article, I would like to table the argument that the "Retail Question" is, perhaps, a red herring as it applies to pyramid scheme analysis.
Specifically, I would like to table the following hypothesis.
Herbalife is a pyramid scheme, even if 100% of its product is sold to ultimate users.
Say what? Are you crazy? Have you jumped the shark?
Let's be clear. This article presents a hypothetical. There is no way that Herbalife sells 100% of its product to ultimate users. There is no risk that this outcome is a reality.
Still, we can imagine this scenario and then analyze the dynamic.
Herbalife's business model deconstructs to include a number of participants in the chain. The company has investors in the form of shareholders and bondholders. The company is public, and so we get SEC-mandated reporting on its business results and a stock ticker on the NYSE to follow each and every day. The company has a management team. The company has a network of distributors. Some are senior, and focus on recruiting almost exclusively. Some are more junior, and try to find new recruits. Some, we are told, are just personal consumers. Then we might assume too that there are customers of Herbalife who are not signed up as distributors, but who actually consume the product. Maybe these folks consume at home or in Nutrition Clubs. If we accept the database of "Selfies" as real, we cannot deny the existence of these people.
The point I would like to make here is that Herbalife is a "Business Opportunity Fraud", even if all these "Selfies" drink Formula 1.
To understand why the pay plan is a fraud, all we have to do is zero-in on the economic outcome for the distributors the company recruits.
When Herbalife recruits a new distributor, let's be clear. Herbalife wants this new individual to take a risk. The risk that the prospect is asked to take is quite simple. There is financial risk, you are asked to risk your time, your reputation is involved, perhaps your self-esteem is thrown into the mix. Maybe there are other variables too?
Still, in order to get a prospect to jump off the diving board and into the pool, the prospect must be convinced that taking the risk is worthwhile.
By now, investors know that Herbalife employs a number of deceptive devices to get prospects to jump. Recruiters lie about things like the income potential, the efficacy of the product, the odds of success, etc. Most often, these messages are delivered in group settings, where the power of group or peer pressure to induce conformity on the prospect is well-tested and repeatedly employed.
We know for a fact that Herbalife is a successful recruiter. Last year alone, 2 million new distributors were recruited. Well over 50% of Herbalife's existing distributor base has been with the company for less than a year.
Once successfully recruited, these individuals are immediately required to do 2 things.
1) Pay a fee for a business pack
2) Acquire an opening level of inventory (you have to have something to sell, right?)
How much inventory a person buys determines how much of a discount the recruit gets. New recruits must decide at the outset. Do I want to become a Supervisor today, or over time?
Let's think about that for a moment. Last year alone, 2 million people signed up to become Herbalife distributors. 2 million people took the risk. 2 million people embraced the sales pitch. 2 million people embraced the idea that there is a world of opportunity.
Q. Can all 2 million people be correct?
The answer, of course, is an obvious "NO".
Think of it this way. What if instead of calling these people distributors, we called them competitors. Herbalife recruited 2 million new competitors last year. Then, the company turned these people loose to compete against one another for retail customers and/or new recruits. The company told these 2 million people that all they had to do to compete was to recruit 5 people each.
That means that these 2 million people are all going to try to recruit 5 people each in the next year. 2 million x 5 is 10 million people.
Then, there is even more good news. Once these 2 million people have recruited 5 people each, then those 10 million people are going to recruit 5 people each too. Presto, the company will have 50 million distributors.
Sounds exciting. Yes?
Here are the facts. Herbalife has never recruited more than 2.5 million people in a single year in its history, and even after 30 years in business, the company has 3.7 million distributors today.
Say what? How can that be? My recruiter told me that duplication was achievable, that building out my downline was doable.
Of course it's not doable.
Because the mathematics behind an endless chain are a fallacy.
Herbalife is a pyramid scheme because it promotes an endless chain of recruits and pays commissions exclusively on the amount of working capital these recruits are willing to risk on the business.
Whatever amount of inventory the recruiter can convince the new recruit to buy triggers an immediate upline payday. The higher the better. This, of course, is the reason the company tiers its discounts to new recruits.
Want a 50% discount? Sorry, it is only available to you if you risk $3,000 on working capital.
Investors are seduced into taking this risk because recruiters promote a fallacy. There is no such thing as a limitless opportunity set. It is mathematically impossible for all Herbalife distributors to build out productive and profitable downlines many layers deep.
Herein lies the deception.
One summer in college, I ran a painting business. I signed up for a franchise, I took a risk, I invested money in ladders and tools and a truck. I invested my time and energy. In exchange for this risk, I was given the exclusive rights to a territory. My territory was Markham, Ontario, Postal Code L6C. No other representative who worked for my company had the rights to sell in my area.
Did I have competition?
Of course. There was a company called College Pro Painters. There were professional painters. I had all kinds of competition. That is the way free markets are supposed to work.
Still, I didn't have to compete for customers with employees of my own company.
Common sense, right?
Of course, unless you start to examine the perverse world of endless chains. Endless chains deliberately promote the recruitment of a relentless chain of in-house competitors. Perhaps most perversely, the compensation plans encourage you to recruit people to compete directly with you, and then to encourage them to recruit even more people to compete directly with you.
What is it you are supposed to be competing for?
Supposedly, the answer is RETAIL CUSTOMERS.
Think about that for a moment. We have a business selling business opportunities to people so that they can make money selling product to retail customers. Then, we promote a marketing plan that intentionally sells more distributor licenses than the retail marketplace needs.
Q. Is there a word for that?
How about Fraud?
Too many salespeople chasing too few customers causes predictable economic outcomes.
#1 Pricing collapses. This why we see product ubiquitously sold for 35% to 40% off SRP (so much for that 25% profit if you are a mere Distributor).
#2 Avg. Volume collapses. While each distributor may be able to find a book of customers, the size of the book is destined to be reduced due to the hyper-competition among distributors in a given territory.
#3 The end-market becomes saturated. Saturation can be defined simply as distributors extracting all economic value from a given geography, leaving no residual opportunity set for a newcomer.
#4 Participants cannot make a Return on Capital. Even as a distributor may find customers, may sell his her opening inventory buy, may liquidate this inventory to real-life personal consumers, the simple truth is that there is not enough business volume to be had to generate a positive return on investment.
#5 As a result, most participants quit in less than a year.
#6 The recruiting juggernaut continues telling the rags-to-riches story to a new wave of optimists.
#7 Those in the upline continue to get paid, even as those at the bottom churn out with an economic loss.
Q. What does any of this result have to do with whether or not the product is ultimately consumed?
The answer is: Absolutely Nothing
The reason the FTC should shut Herbalife down is simple. The company's entire Marketing Plan is built upon a big lie. The lie is simple and obvious to see. The company sells the idea that opportunity is limitless in a finite world. This idea is a mathematical absurdity.
Still, over the past 5 years, the company has deliberately and intentionally recruited over 8 million people and then unleashed these people around the world to compete against one another without any territorial restrictions whatsoever, while simultaneously encouraging them to recruit new people to do the same thing.
Is it any wonder that most of these people fail, and fail miserably?
Endless chains are inherently deceptive. They are deceptive if everyone buys product to inventory load. They are deceptive even if all the product gets consumed by those willing to "Take a Selfie".
Because the individual who is taking the risk, the distributor who is asked to build a business is, plain and simply, thoroughly and completely abused by his business sponsor.
- price discrimination
- no territorial exclusivity
- the deliberate and intentional sponsorship of hyper-competition
- onerous and usurious Shipping and Handling upcharges
- 100% responsibility for all soft dollar/marketing costs
- empty promises
- the sale of a fallacy
Each and every single one of these elements of the Herbalife business plan should be an obvious and outrageous violation of Section 5 of the FTC Act and indicia of a global pyramid scheme.
Herbalife's cynical response?
Wanna Take a "Selfie"?
The sooner the FTC shuts down Herbalife, the better.
Investors who focus exclusively on "The Retail Question" are missing the point entirely.
It is impossible to sell a business opportunity to a salesperson promoting his/her success without providing some territorial license, exclusivity, or limitations.
This has to be the most commonsense observation that anyone could make about the sordid nature of endless recruiting chains.
By design, the purpose of the pay plan is to saturate markets to the point where it becomes virtually impossible for anyone who is actually striving to be a retailer to make any money whatsoever.
Herbalife is like Standard Oil in reverse. The pay plan promotes too much competition for a finite opportunity set, and then doesn't stop.
Whether or not the product is personally consumed is an irrelevant variable.
If the HLF pay plan promotes an endless chain, it should be shut down.
De minimus, the entire industry needs new speed limits from legislators and regulators alike.
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.