Tomorrow investors will be treated to a documentary featuring real-life victims of the Herbalife (NYSE:HLF) fraud.
Q. How can it be that a company that generates so much sales leaves so many of its salespeople holding the bag?
Let's try to get down to brass tacks.
Investors often refer to Herbalife as an MLM. I prefer to think of it as an ELM. What is the difference?
- An MLM is a multi-level marketing firm. Many traditional salesforces could certainly be considered multi-level.
- An ELM is and ENDLESS level marketing firm. Participants are paid to recruit without any limitations nor end to the recruitment pattern. Ideally, participants recruit ad infinitum.
In this article I would like to attempt to debunk what is commonly known as "The Retail Question". This question is articulated in a brilliant article written here.
The writers ask the question "How do we tell the difference between a legitimate MLM and a pyramid scheme?"
Personally, I think the title of the article would be better if it read something like. "How do we tell the difference between an MLM and a pyramid scheme when it isn't obvious?"
The idea behind the paper is simple. The authors argue that if most of the product sold through the MLM salesforce is bought by people outside of the sales structure then the company is legit. If not, then the company is a pyramid scheme.
I submit, respectfully, with regards to those who argue this position, that this argument is simply not that important in the case of Herbalife which is an obvious endless chain.
First, let's establish what an endless chain is.
Participants sign-up and pay a fee to the sponsor of the pay plan. In the case of Herbalife the fee is $59 - $100.
In exchange for that fee they get the right to purchase product, the right to resell that product plus the right to recruit others to do the same who in turn gain the right to recruit others to do the same.
The pay plan is designed with purpose and intent to promote and encourage duplication. Duplication is accelerated when the pay plan pays commissions based upon product purchases and not retail sales.
E.g. In the Herbalife pay plan, every time a downline recruit makes a wholesale buy an upline commission is immediately triggered. Effectively, commissions are paid on activities that stuff the channel or load inventory into the channel. This is analgous to juicing the pay plan with steroids.
Whether or not real, retail demand exists a recruiter can indeed make money if he can convince a downline recruit to buy an up-front amount of inventory. This kind of scenario would make Herbalife an obvious pyramid scheme. If all purchases are made within a closed network, surely the business is a scam.
Herbalife, of course, helps drive this incentive by discriminating on the wholesale price it charges its most junior recruits.
But what if product actually makes its way outside the pyramid, can the pay plan still be a scam? The answer should be "Of course".
To be clear, if I sign-up as a Herbalife distributor with designs on the business opportunity (let's zero-in on this segment of the salesforce in the interest of simplicity) I can only make money one of two ways.
Either I resell the product I buy at a mark-up and generate a positive gross profit margin or
I recruit others into my own salesforce who then resell the product at a profit margin which generates a commission for me.
I would like to introduce the following argument into the debate to advance the pyramid scheme argument in a new direction maybe.
AVERAGE VOLUME MATTERS
Q. Is it possible for 100% of all product purchased to make it to retail customers but still have those who are pursuing the business opportunity lose money?
Q. How do the economic forces unleashed by an endless chain of distributors impact the profitability of a distributorship?
Endless chains are deceptive because they advance a mathematical fallacy. Simply, they promise participants a positive economic result even as the end-market for products is obviously finite. The point I would like to advance is that the end market is finite whether sold at retail or not.
If I consider the simple example of an Island economy with 100 people, I can illustrate this point.
Assume an Island called HerbalIsland.
Assume a population of 100.
Assume everyone wants to get skinny and buy Formula 1.
One day an exporter shows-up on the Island and sells Distributor #1 a license to sell Formula 1. He then tells this person that he too can resell this license to anyone on the Island.
On Day one there is one distributor and 99 customers. As a monopolist, Distributor #1 can charge the full SRP for HLF product.
Instead, he decides that the far side of the Island is too far for him to reach so he decides to recruit a friend to sell the product. Now the Island has 2 distributors who each have 48 customers each. The exporter then tells them that the secret to great wealth is not to protect those retail licenses for themselves but to sell them on to the rest of the inhabitants on the island.
Soon enough, everybody who wants to buy Herbalife on the Island is signed-up with or as a distributor.
The math would probably flow as follows Distributors : Customers.
32 : 2.125
Everyone is in the downline of the first 2 people. Everyone is consuming the product.
Q. Is everyone making money?
The answer to this question should be obvious. The answer is an Obvious "No".
By the time the island has 32 distributors there can only ever be an average of 2 customers per salesperson. This kind of business would never make money. And herein lies the core deception.
Business opportunity seekers who joined the endless chain late in the game are left with very few customers to service. That is to say that even if 100% of the product they buy is sold to people who actually wish to consume the product, THERE IS NOT ENOUGH VOLUME available in the marketplace to support a profitable business.
The word we would use to describe this result of an intentionally Darwinian pay plan is saturation.
When business opportunity seekers can't make any money one of two things happens.
a) they lose money or
b) they quit
Every single day in this country Herbalife recruiters conduct opportunity meetings. In these meetings they tell prospects that they can make money one of two ways. They can retail or they can recruit. Recruiting involves finding two people who in turn find two people who in turn find two people. This story that is told is an obvious lie.
The math doesn't work. It is the proliferation of this mathematical fallacy that makes Herbalife's marketing plan a fraud, it is the selling of this lie that makes it illegal, and it is the promotion of this nonsense that makes it an ELM. (Endless Level Marketer)
Whether or not product is consumed at retail by "ultimate users" or not is a moot point for ELMs, or at least it should be in my view.
A pay plan that encourages the sale of too many distribution licenses to service a finite set of end-users is destined to see participants fail at the business opportunity.
Q. Do we see evidence of this dynamic with Herbalife?
The answer is of course.
The first and obvious data point is the massive churn/turnover in the salesforce. Herbalife recruited 2.1 million people in 2013. 1.6 million resigned in the same period. In Q1 of 2014 599k were recruited. 400k resigned. A huge % of Herbalife's salesforce is failing each and every year.
If they were making money, why would they ever leave?
Why are they failing?
All empirical evidence of retail sales data we have suggests that the actual retail selling price for HLF product is, at best, 65%-75% of SRP. Websites like herbalwell.com or herbalivingshop.com routinely offer product at 65% of SRP including free shipping. Too many distributors chasing too few customers unleashes a powerful economic force called price elasticity. As distributors compete aggressively for customers pushing out the supply curve, prices fall. Specifically, the price of Formula-1 in the end market drops to a market clearing price that makes economic returns scarce for anyone not generating significant sales volume. Herbalife also taxes this activity with S&H upcharges, etc.
In Mexico, the company has over 30,000 Nutrition Clubs. Think about that for a moment. How could Herbalife corporate conclude that it would be profitable for its network of distributors if it allows an endless chain of Nutrition Clubs to exist?
Q. Are you aware of Herbalife corporate imposing any restrictions on the growth of its distributor base at all, or is it always relentlessly pursuing the expansion of the base of the pyramid?
The answer, of course, is obvious.
Rational economists know that the end-market for a given value proposition can only absorb so much sales coverage. That is why we don't see a Wal-Mart (NYSE:WMT) on every street corner, a school on every block, nor a million people lined-up for every Springsteen concert.
Each micro-economic value proposition only appeals to a specific and finite segment of the macro-economy.
Most economic participants compete hard for market share by constantly tweaking and fine-tuning their business strategies to steal share from competitors and/or penetrate new markets.
Herbalife's marketing plan is unique in its perversion.
The answer should be obvious by now. Instead of sponsoring a salesforce to compete against other market participants for market share, the Herbalife pay plan sponsors a sinister and sadistic endless chain of new recruits year in and year out who are supposed to compete against one another for retail customers.
Herbalife's pay plan intentionally unleashes forces that are destined to extract all end-value from the retail landscape without any regard for how these forces inevitably impact its salespeople.
Put another way, the promoters of Herbalife's pay plan, the company's most senior recruiters deliberately use and abuse junior salespeople. They tell them the world of opportunity is infinite. Meanwhile, they continue to sign-up new competitors for that finite opportunity each and every day.
As it stands today, Herbalife has 3.9 million distributors. Most of them do not make any money and yet if Herbalife had its druthers they would recruit another 3.9 million tomorrow. How is that for upside down thinking?
If all 3.9 million recruited 4 people, this year alone Herbalife would end the year with 16 million new recruits. How does reality square with this fallacy?
If Herbalife really and truly cared about the profitability of its distributors it would be shrinking its # of licenses and increasing the average volume per sales person. Instead, it is relentlessly expanding the number of salespeople it has. Average volume per salesperson has absolutely no leverage in the model whatsoever.
I have read Dr. Keep and Dr. Vander Nat's paper on differentiating an MLM from a Pyramid Scheme in detail. I have discussed the arguments tabled in this paper in detail with Dr. Keep. Most certainly, this academic exercise and economic model is a great way to help regulators and analysts uncover fraud in an opaque world.
Still, I submit, respectfully that the identification of marketing fraud in the context of an obvious pyramid scheme should be much easier and simpler to identify. Do we need to even ask "the Retail Question" where an ELM is concerned?
How is it we get a publicly traded company that sells $5 billion worth of shake mix while turning over its salesforce so often?
A. Too many salespeople.
ENDLESS CHAIN MARKETING PLAN
It's just that simple and obvious.
Herbalife generates lots of sales volume. John Hempton might actually be right when he says he has seen firsthand people consuming formula 1 shakes.
My question is simply this. What does any of this have to do with whether or not Herbalife promotes an endless chain of distributorships?
If you want to identify an endless chain or pyramid scheme it should be obvious to spot.
Put simply, the moment any pay plan is designed to deliberately sponsor, promote, and encourage the intentional saturation and ad nauseam proliferation of an endless chain of recruits then that marketing plan is selling a lie. Specifically, it is selling a fallacy.
Whether or not the product in question is ultimately consumed or not does not alter the end stage of the recruiting scam.
Anyone who signs-up late will simply find it difficult to find and recruit retail customers so as to generate a positive ROIC.
Too many people chasing too few customers inevitably bids economic value out of the economy.
I can walk into a Nutrition Club tomorrow I am sure. I can probably see a shake being mixed. I might even see someone involved in a weight loss challenge. This is all interesting and maybe even heartwarming.
As an investor, however, what I am more interested in is the P&L for these marginal entrants. Isn't this what regulators should be concerned with too?
Herbalife is selling a business opportunity.
Isn't it fair to question whether or not its distributors make any money? Shouldn't economic failure in the salesforce be the primary evidence of fraud?
Of course it should.
How much money do N.C. operators make? How many close every year? How many salespeople turnover? What losses do they absorb?
Herbalife has 3.9 million salespeople. Sounds impressive, right? Not when you calibrate average revenues per salesperson, etc. Not if you start to look at their individual P&Ls.
The point is simply this.
In a perfect world, pyramid schemes make products that have no intrinsic value making them easy to spot. That is to say, the product is an obvious device to separate fools and their money. These kinds of scams are outrageous and should be obvious to spot. However, are they any more or less sinister than a straightforward endless chain scam?
To answer this question think about the following. What would we say if McDonald's (NYSE:MCD) allowed anyone to open a restaurant on every street corner? How would we feel if Bruce Springsteen sold 100,000 tickets to a concert venue that only holds 50,000 people? What would we say about a man who secretly marries more than one woman in separate jurisdictions?
The answer, of course, is obvious. In each case, the person in question is deceiving their counterparties. This is the essence of fraud and the reason why Herbalife should be shuttered.
Herbalife sells "The American Dream".
Ostensibly, there is nothing wrong with that idea. The problem is they sell it too many times. They sell it to too many people. They place no restrictions on the number of people who can peddle their wares, and therefore they sell false hope and mathematical nonsense.
Herbalife is an endless recruiting chain whether or not product is "ultimately consumed".
Because Herbalife is not an MLM it is an ELM. ELMs are "inherently fraudulent" and should be shut down by regulators because they always leave the last one in holding the bag unable to fill out their downlines whether with "retail customers" or new recruits.
The math is so simple it is almost ludicrous.
Herbalife pushes its supply curve out to the point of obvious pain. It intentionally unleashes a WWF like cage match between and among its own salespeople. Is it any wonder that the only ones left standing at the end are the ones who got into the cage first and then recruited others into the cage, and so on and so forth.
Herbalife is the marketer of an endless chain of salespeople. Full Stop.
Retail sales or not - this should be enough evidence to shut it down.
Tomorrow's video will put a face to this nonsense.
Hopefully regulators will be watching with interest.
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.