Herbalife (NYSE:HLF) sold $1.2 billion worth of nutritional supplements last quarter. The company also recruited 599,000 new Members into its distributor base.
Q. Why did they join?
A. To get skinny or B. To get wealthy
Q. Are purchases of product driven by:
A. Participants attempting to succeed as entrepreneurs or B. Participants trying to lose weight?
Q. What does the the revenue mix look like?
One of the simplest ways to arrive at the conclusion that Herbalife sponsors and promotes a global confidence game that is a recruiting scam is to imagine that it isn't a global confidence game.
Q. What kinds of things would be true if Herbalife was the legitimate marketer of a successful consumer product that was demanded by consumers seeking a cure for personal obesity?
Herbalife's Business Model is fairly straightforward.
The company, itself, manufactures and/or outsources the manufacturing of its high-priced products for which there are a multitude of competitive substitutes for any given SKU.
The company then outsources its salesforce by sponsoring a network of independent distributors to sell these products.
Distributors pay a small fee to the company for the right to sell these products to customers. They also gain the right to recruit other salespeople into their downlines and to earn commission payments any time a downline recruit orders product.
Initially, all distributors are faced with a simple choice.
A. Try to resell product as a retailer or B. Try to recruit new distributors into my downline?
Q. How would we expect participants to behave if Formula 1 shake mix was a differentiated product with meaningful brand equity?
Q. How would we expect participants to behave if Herbalife manufactured Crayola Crayons or Tide Detergent or Clorox Bleach or Ray Ban Sunglasses?
The answer should be quite obvious. What we should expect to see would be the legitimate proliferation of a multi-level salesforce that would be structured to service customers geography by geography around the world.
We should also expect the following things to be true:
- Demand for Distributor Licenses would be Robust
- The Supply of Distributor Licenses would be limited by the company
- The value of an individual distributorship would increase over time
- Free market forces would find a market-clearing price/value for a distributorship where an upline sponsor would be indifferent as to selling a sales license to a downline participant or preserving the retail opportunity for himself.
- Distributor licenses would be stable with low turnover
If Herbalife was a legitimate MLM, the company would surely strive to exert some level of control over how distribution licenses are granted, how many are granted, how much people should pay for them, and whether or not territorial rights are attached.
The company might ask questions like:
- How many levels should there be in my MLM?
- How many commission levels should ther be in my MLM?
- How do I tie commissiones to profitable retail trade?
These kinds of policies would promote rational interactions between and among the members of the company's salesforce and the company itself.
The company would be on the side of its salepeople rather than promoting policies that intentionally victimize them. Eg. Rather than an ENDLESS CHAIN of salespeople competing vs. one another for a finite amount of customers, distributor supply would be balanced with end-market demand with sales licenses granted exclusively and not arbitrarily.
Put another way, the purpose of the salesforce would be to service real retail customers without cannibalizing the economic prospects of the distributor who competes along side you.
Q. Is this how Herbalife works as a company?
By now, the obvious answer is a resounding "No".
Unlike other successful consumer brands, Herbalife's core product is not Formula 1 shake mix. Rather, the company's core product is its Income Opportunity.
Herbalife sells this opportunity to literally anyone with $59 to spend and the disposition to buy an opening slug of inventory.
By design, the company pedals an ENDLESS CHAIN of distributor licenses.
Effectively, the company deliberately and intentionally unleashes hyper-competition between its salespeople.
The economic outcome from this set of policies is both predictable and predetermined.
As the supply of distributors is pushed out beyond the profitable level of demand for Formula 1 shake mix the following 3 things occur.
- The retail price of the product falls well below SRP
- The retail profit pool on both a transaction basis and an aggregate basis is squeezed
- Avg. Retail Volume attainable per salesperson falls
- The potential to make money as a retailer is eliminated
As a result, marginal entrants fail at the business opportunity and churn out of the business.
I must admit, I remain fascinated that market observers remain preoccupied with some of the specific mechanics of Herbalife's pay plan.
- Does the company pay for recruiting or not?
- Does it operate like Burnlounge or not?
- Is there internal consumption or not?
- Does the product have intrinsic value or not?
To be sure, these are all very interesting questions. Still, none of them seem to trump the obvious mathematical outcome that occurs when the sponsor of an MLM deliberately and intentionally allows its recruiters to recruit an ENDLESS CHAIN of recruits.
To repeat - Herbalife promotes the proliferation of an ENDLESS CHAIN. FULL STOP. This is the trump card that makes it the sponsor of a fraud of epic proportions.
Anyone with a basic understanding of the laws of economics should be able to see how this policy dooms participants to economic failure.
Perhaps we can think of some other examples that might illustrate the point.
Did you ever play Musical Chairs as a kid?
The game is simple.
Kids run around chairs. Each time the music stops each child has to find a seat on a chair. Each round a chair is removed. (The supply of chairs is reduced). Each round the value of a chair increases. Ultimately, the game is concluded when there is one winner sitting on one chair while all other participants have been eliminated. It is a mathematical fallacy to tell all participants in a game of musical chairs that they will be a winner.
Herbalife's business model functions in much the same way. There are a finite amount of customers who are willing to buy Formula 1 shake mix around the world. Still, the company continues to expand its supply of salespeople to service this opportunity set.
Q. Isn't this policy on its own enough to conclude that the company engages in deceptive marketing practices?
2.1 million people were recruited last year alone. Then, each of these people were instructed to find new recruits. Herbalife's pay plan is constantly pushing out the supply curve for its salespeople.
Of course, the laws of economics work and work well. In true Randian fashion, the free markets police themselves.
As more recruits are recruited into the salesforce, more recruits fail and fail quickly.
The laws of Supply and Demand work. Pricing falls and takes the profit pool along with it.
This dynamic is known as SATURATION. The scheme proliferates simply because the company's recruiters are able to find replacements for the distributors who are in the process of failing.
Meanwhile, the house always makes money.
As long as the Herbalife economy is perpetually replenished with new "entrepreneurs" the ENDLESS CHAIN continues to survive.
In Herbalife's case, the company has been relentless at expanding geographically in order to continue to source a steady supply of new recruits while also penetrating specific affinity groups with its stuff and nonsense.
Let's pretend for a moment that Herbalife was a legitimate MLM with a legitimate consumer product:
- Would the company be inclined to grant more distributor licenses or less?
- Would we expect the average value of a distributor license to increase over time or remain immaterial?
- Would an abundance of fish in the retail pool make distributors want to protect their retail licenses or share them?
- Would the company want to PROMOTE AN ENDLESS CHAIN of salespeople or to prevent it?
Herbalife is not a legitimate MLM that services lots of retail customers through a network of profitable distributors.
Rather, the company is an obvious pyramid scheme with participants peddling an income opportunity to anyone who is willing to listen.
This emphasis on recruiting is what makes the company a scam.
This promotion of an ENDLESS CHAIN is what makes it economically impossible for junior distributors to succeed as entrepreneurs.
Herbalife is not a pyramid scheme because its product has no intrinsic value. Herbalife is a pyramid scheme because its distributorships have no intrinsic value.
Ergo: It's a business opportunity fraud.
It simply sells too many sales licenses therefore dooming most participants to economic failure.
This is an obvious violation of Section 5 of the FTC Act and is reason enough for the company to be shut down on its own.
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.