Over the past five years Citron has written about numerous Chinese companies that were being less than forthright in their disclosures in the U.S. markets. But we now turn the tables - exposing a U.S. domiciled company that is being far less than honest about its operations in China - defying Chinese government regulation while exploiting an ambitious population eager for a formula to climb the economic ladder.
Introducing Nu Skin (NYSE:NUS)
In the United States, multi-level marketing (MLM) has become part of our economic fabric. It is not our proudest achievement, but nonetheless it has become a part of our society - one that sells dreams along with an array of overpriced products that most people can live without just fine. The U. S. has established a patchwork of little understood regulations that provide some protection for the public from the most abusive forms of pyramid schemes, mostly under the jurisdiction of the U.S. Federal Trade Commission. (See “Lotions and Potions” at the FTC website here. The SEC also has both concerns and regulatory oversight in this problematic area here.)
By contrast, China prohibits multi-level marketing strictly and in entirety. Pyramid schemes create victims by creating an endless chain of recruits who recruit new recruits into a wealth transfer scheme which cannot possibly be sustained. Therefore the vast majority of the participants lose their money. Often pyramid schemes are cloaked in the sale of an overpriced product, with new recruits being required to “invest in inventory” to gain or maintain certain levels of membership which most will be unable to achieve. These abusive business models are understandably outlawed under Chinese law.
China does have a law which defines and permits only “direct selling." Much like many Chinese companies which ignored the regulatory laws of the United States, it is the opinion of Citron Research that Nu Skin is allegedly violating the laws of the PRC, and its entire Chinese business operation could be in jeopardy of seizure and other substantial risks.
Before we introduce the evidence pointing conclusively to widespread violation of Chinese law, this discussion begins with the importance of the China market to Nu Skin. The company was beset by challenges from various U. S. regulators in the early 1990s, when several states were investigating the company for everything from misleading sales practices to operating a pyramid scheme. Nu Skin realized that its future riches were not on these shores, but rather overseas, and particularly in China.
- Greater China comprised almost 75% of Nu Skin's year-over-year revenue growth in Q2.
- Greater China represented less than 10% of the company’s revenue just three years ago, and is now 33.6%.
- The average distributor in greater China purchased roughly $1,200 worth of product in Q2, almost triple that of the U.S. and double the average levels of prior periods in China.
- The future of the company, and in particular, the growth story that underpins the value of its stock, is dependent on China. As CEO Truman Hunt just stated "Emerging markets, particularly China and South Asia, will continue to drive healthy overall growth rates ..."
- Sales in North and South America contributed just 12% of revenue in the last quarter, with Europe just 7.7%.
So the Chinese operation is contributing very materially to the company’s overall financial results, particularly in shoring up its flagging growth in other regions. (Details provided below.)
With the U.S. consumer becoming increasingly resistant to the core business of Nu Skin, they just moved their entire dog and pony show to China. But is it legal?
Here is what Nu Skin says it does. In its most recent 10-Q, Nu Skin describes its business operations as:
“The company operates in a single operating segment by selling products to a global network of independent distributors that operates in a seamless manner from market to market, except for its operations in Mainland China. In Mainland China the company utilizes an employed salesforce, contractual sales promoters and direct sellers to sell its products through fixed retail locations.”
This disclosure language is extremely significant. Nu Skin acknowledges that operations in China are a separate and distinct exception – obviously they cannot operate in China the same way they operate everywhere else in the world.
Why? Because China has strict laws regulating direct selling as well as a strict and clear and total prohibition on multi-level marketing.
Nu Skin’s disclosures go further. They state:
“Our operations in China are subject to significant government scrutiny, and we could be subject to fines or other penalties if our employees or direct sellers engage in activities that violate applicable laws and regulations. The legal system in China provides governmental authorities with broad latitude to conduct investigations. We anticipate that our business will continue to attract significant governmental scrutiny, particularly as our business grows and the number of sales employees and contractual sales promoters continues to increase.”
The risk here is for U. S. investors to regard the above warning as “just boilerplate." Citron believes that readers will understand the above-described looming threat in a completely new light after reviewing the evidence presented in this report.
What Nu Skin Says they Do: Direct Selling (here)
Nu Skin obtained its business licenses and established its presence in China by having agreed to operate under the “Regulations on Direct Selling Administration," essentially promising to do business as “a direct sales organization."
The direct selling law (linked above) is quite clear – it was structured to address a business model in which a company could legally engage direct sales staff (note all the law’s 60+ explicit references to “door-to-door salesmen”) who were expected to sell products directly to consumers - a simple and well-understood model, if somewhat dated by Western standards, that might boost employment and create a channel for the distribution of goods to consumers.
This is a humble and straightforward business model that is certainly not founded on the promise of making millionaires. However, note that this law, in article 27, it makes the company, not simply the salesmen, liable for violations.
It is Citron’s opinion that the most fundamental point of this report is that Nu Skin’s management used the promise of conducting the direct sales model to gain the permission of Chinese authorities to grant it business licensing, then pulled a classic bait-and-switch maneuver, and is actually implementing a pyramid sales scheme on a grand scale.
What Nu Skin Actually Does: Pyramid Selling (here)
Citron believes Article 2 of the Chinese Pyramid Sales law is utterly clear in stating its intent and it is unambiguously strict in its implementation:
“The term pyramid selling as mentioned in this regulation refers to such an act whereby an organizer or operator seeks for unlawful interests, disturbs the economic order and affects the social stability by recruiting persons, calculating and paying remunerations to recruiters on the basis of the number of persons a recruiter has directly or indirectly recruited or the sales performance, or asking the recruiters to pay a certain fee for obtaining the qualification for participation.”
And lest you think that Hong Kong (where the majority of Nu Skin's China revenue is being reported) look at the new Pyramid Schemes Prohibition Ordinance, intended to close loopholes in the former law and toughen penalties jjust put into effect this year (here)
The question is simple: Does Nu Skin operate an MLM in China?
Yes Or No
It’s a simple question because the answer is just “Yes” or “No."
Citron will now present evidence uncovered that confirms that Nu Skin is in fact operating as an MLM in multiple cities. Citron associates engaged some undercover “customers” who helped us expose the truth. While Nu Skin is a registered direct seller, we believe they violate laws regulating direct selling, as well as the prohibition on pyramid sales, specifically by supporting the creation of a multi-level pyramid compensation scheme, as well as requiring purchases in order to participate in sales commissions or salary. Over the course of three weeks leading up to the company’s recently held sales convention, a representative of Citron met with numerous Nu Skin salespeople. They consistently presented a completely different compensation model that is not written in any of the company’s literature. Thus the hand-drawn sketches.
All of the conversations we are presenting have been taped and uploaded to a dropbox. The purpose of these is to validate the translations of these interchanges posted with this report.
Evidence Point #1: On June 19 a Citron researcher met with sales representative Li Shanshan from Nu Skin in Hefei (a city of 5.7 million population). Below is a synopsis of the meeting. All highlighting has been added by Citron to indicate content demonstrating a blatant violation of direct selling principles and the offering of a pyramid MLM compensation scheme. Even though this interview is presented out of sequence, we start with this one because the representative from Nu Skin actually drew a pyramid to use in her explanation of Nu Skin’s compensation scheme.
Here is another transcribed conversation from the same day. Violations are again highlighted.
These conversations are from visits which are a follow-up from the June 6 visit in which the salesperson says whatever they seem to need to promise unlimited riches for the new recruit to join the pyramid. Just read the attachment and follow the multiple violations.
Here are the notes from a another recorded conversation at the Nu Skin office in Hefei.
It should be noted that the deceptive practices of Nu Skin in China are widespread and not limited to just a few individual distributors. Next are the notes of a representative while visiting the Beijing store and requesting information about working with Nu Skin.
and then ....
And more of the same from Shanghai:
In none of these cities did we find a recruitment conversation that reflected the written operational policies and procedures of the company. Note that both multi-level commissions and the requirement to buy goods to participate in training (and thereby commissions) are the main abuses of pyramid schemes.
Computer Systems Needed to Implement an MLM Compensation Scheme
Investors need to ask themselves: Could a pyramid compensation plan possibly be propagated without the company’s knowledge and consent?
Think about it. In a multi-level commission structure, each invoice, each retail sale generates a variable number of commission sharing transactions, which have to be accumulated among the credited sales person and all their “upstream” counterparts. Even a few thousand transactions per month would create a nearly impossible computational task without a central computer system. How could this compensation system possibly function without the company’s involvement at its core?
The Story in the Numbers
There are very disturbing signs even though Nu Skin’s revenues in China appear to be booming in the past quarter. First, roughly two-thirds of the Greater China’s revenue comes from just 2 SKU’s. (This is likely why the CFO was reluctant to give the sales-by-product to one analyst on the call.) The majority of those sales were made at the China convention.
Overconcentration of SKU’s on products hyped at the Convention, related to recruiting
The most likely explanation is that the bulk of the sales growth was concentrated around the “business opportunity” and likely temporary. Is buying a 30-day supply supplements at $160 per month or a $300-plus anti-aging skin treatment system and trying to re-sell them in China a sustainable business? These products were heavily hyped at the convention.
Spike in Revenue-per-distributor ratio in China, Implies Alarming Risk of Channel Stuffing
This is a lot of product to re-sell and revenue was probably borrowed from Q3. Even more eye-popping is the product purchases per avg. executive at appx $13K - These sales leaders account for the vast majority of the business done in China. The most important question on the call was largely unanswered.
“... any sort of granularity you can give on how you track inventories, or where the product is going…?”
|Avg Revenue per Distributor||Q1 – 2011||Q2 – 2011||Q3 – 2011||Q4 – 2011||Q1 – 2012||Q2 – 2012|
Chasm Between Sales Leaders and Distributors Is Red Flag:
Never in the past decade has there been such a big difference between executive growth and overall distributor growth. While one could argue that this is a bullish sign, it clearly goes against management’s assertion that the vast majority of its products are being purchased for consumption. The reality is that a surge in sales leaders necessitates a surge in inventory purchases, such as “Business Builder packages” (here), along with recruiting-related purchases to obtain status and commission eligibility.
|Year over Year Distributor vs Executive Growth|
Remember that a high percentage of products purchased for purposes other than end user consumption is a critical indicator of a pyramid scheme in the FTC’s estimation. MLM companies somehow are always able to calculate their pyramid commission payouts, but seem unable to ever track how much of their product is actually being sold to those outside the sales pyramid.
Nu Skin’s Sales Driven by Promises of Achieving Massive Personal Wealth
The common themes of the above interviews are consistent and pervasive: The point of the conversation is to induce the contact to join up to become wealthy, by buying product to become a trainee, and ultimately to become successful by recruiting multiple levels of others whose sales will result in 5% commission earnings per level. These are all the classic techniques of pyramid schemes.
The Chinese internet is rife with examples of the scheme in action. There are numerous “fan sites” and Weibos reinforcing the same theme of personal wealth creation, rather than product features and benefits.
Here is just one of many examples of some content created by a rep on a “fan site." It’s becoming apparent that they all post the same sort of promotional material and quotes. The image they are trying to convey is you live this carefree lifestyle and not have to go to “work” as a rep. There is the possibility of driving Ferrari’s and making millions while helping people and realizing your true potential. This is a typical entry:
“Our home will have lakes, mountains, soccer fields and a small version of Treasure Island. You will have a private jet and a fleet of motorcycles and be called the Ferrari Prince because you have the largest collection of Ferrari's. This is the life of the successful Nu Skin rep. The Nu Skin record of $3.3m U.S. monthly income will be beaten by a Chinese – possibly you.” (here)
This is a blog from a disgruntled Nu Skin sales (a bit dated, but right to the point) (here).
It states that the company claims one thing but does another to the Chinese government and to the sales reps. From the blog, it seems that the sales reps are required to buy $1,500 of product and have a $10,000 a month quota to avoid getting fired. Once you meet your quota, there are other hoops to jump through to get the 15% small team bonus and the “6th level” 5% bonus. New Nu Skin recruits goes through four phases:
1) Brainwashing and chanting slogans
2) Half a year or so of running down savings, family and friends
3) Infighting with team members for prospects
4) Giving up
As a direct consequence of forcing recruits to buy inventory for themselves or to sell to others, there is a lot of Nu Skin product being offered on Taobao, Alibaba and other commerce sites, often at steep discount, which is in violation of the company’s sales policies. For example, there are 86 listings from 36 suppliers here as of the date of publication. (here)
MLM Impact on Culture and Cult-Like Behavior
One of China’s concerns in outlawing pyramid selling schemes is their tendency to create cult-like behavior and the attendant harm to the basic social fabric. This goes against many of the basic cultural values of China. It undermines family ties and close friendships by encouraging recruits to regard their family and friends as sales targets - little more than prey. It manipulates economic vulnerability and emotional weakness to convince people to subvert these values with the power of psychological manipulation.
Take a look at these videos of the recent Nu Skin convention in Hong Kong and decide for yourself. The first is a speech given by Cai Si Gun on June 20, 2012 (he lives in mainland China):
(Hint: These thousands of people are not celebrating face cream or nutritional supplements.)
“Good morning everyone.
As I stand here, I remember the Hong Kong convention several years ago. Back then, I sat on your side of the stage. I was seeing what you see now. All the lecturers on the stage looked like ants because I sat so far away from the stage. At that time I wondered, when can I be on the stage making speeches? So today, I want to thank Nu Skin for making my dream come true. Because I think Nu Skin can help all people improve their life. Many people ask me, why did I want to join Nu Skin? The answer is simple. It is because I love my wife. Do you think a good husband should be successful?
Everyday my wife would come home around 10 p.m. She worked late because she was a finance manager. We had just gotten married, so you know I wasn’t happy about that. On top of that, every day when she got home, she would complain about having too much stress. So I began to think of something for my wife to do. At this time, a couple approached me and told me about Nu Skin. Without thinking too much I told them I wanted to join. I know only a few people like me. I gave my wife Nu Skin as a gift. It was really working, she liked it so much. She wanted to join Nu Skin and she wanted me to join with her. Back then, my hobby was playing cards. I spent a lot of time playing cards because I didn’t have a dream, I felt empty. My Nu Skin trainer’s name was Wangyi, he gave me the idea that nothing is more important than how much money you have. He said I should focus on something where I can teach someone else to make money by working for me. Nu Skin is all about appreciating your predecessors because they help make you successful. They taught me how to catch an opportunity and how to overcome obstacles. For example, one manager asks two employees to investigate the market for shoes in Africa. The first employee told the manager Africa didn’t have a good market for shoes because Africans don’t wear shoes. But the second employee told the manager the market for shoes in Africa is very good because there are not a lot of shoes being worn there. This example just goes to show you everyone sees the world differently. You cannot change the world, but you can change your mind. Don’t scare yourself; you should try to do something. If you never try something then you will never know the answer. Like now, I did it and I succeeded. Now I ask my friend to join Nu Skin, not only because it’s my job, but I also want to help them be successful, beautiful and healthy. If you join Nu Skin, the challenge is how to control your emotions. It’s very easy for me because I think in a positive way, which helps me accomplish things others think are impossible. The more people you introduce Nu Skin to, the more people who will see the potential upside. Thank you."
The reality is that the vast majority of recruits to pyramid schemes lose the money they are induced to pay for inventory in overpriced products they can never legitimately sell for consumption.
But the consequences are far worse. Pyramid scheme MLM's are an invitation to cult behaviors, which predictably devolve to a variety of techniques bordering on brainwashing to convince their recruits that:
- It is a cause for celebration to yearn for wealth regardless of the consequences
- Any failure is the recruit’s own fault and responsibility, based only on their own lack of motivation to be rich and successful
- They should pervert relationships with their own families and friends by treating all of them as marks for sales and recruitment
Consequences of Violating the Law Prohibiting Pyramid Selling
(See in particular Articles 14, 17, 18, and 19 from the law linked above.)
China’s laws are unambiguous and harsh with regard to pyramid sales. Citron suggests that all Nu Skin investors consider the powers granted to the regulatory body responsible for this prohibition, the Department of Industry and Commerce Administration. These include:
- Ordering cessation of violating activities
- Investigation of anyone involved
- Carrying out on-the-spot inspections by entering into the business, training gathering places, etc.
- Copying, sealing or seizing relevant contracts and records
- Sealing up business places suspected of being involved in pyramid selling
- Applying to the court to freeze unlawfully transferred or concealed funds
... and that is just during the investigation phase.
(The implementation of seal-up or seizure or any measure prescribed in the above actions (seal-up or seizure) requires written approval of the principal leader of the Department of Industry and Commerce Administration at or above the county level, in advance.)
There’s also a “shoot first, and ask questions later" component (Article 17):
“Where it is in an inconvenient area or the investigation and handling of the case will be affected if the seal-up or seizure is not timely carried out, the seal-up or seizure may be carried out in advance and the decision on seal-up or seizure shall be made up within 24 hours and be delivered to the parties involved.”
And the Department also has the right to promulgate a warning or a notice to remind the general public.
Political Conditions in China
Citron notes that China is in the midst of a carefully planned 10-year governmental power transition. The theme of intolerance of corruption is particularly strong at these transition points, and the government has been responding in numerous ways to this social concern. Citron wonders whether the incoming government will be as lenient as the outgoing, in terms of allowing this massive pyramid scheme to grow under its watch.
Nu Skin investors are exposed to the massive risk of its China operations coming to an abrupt halt due to violation of the PRC’s and Hong Kong pyramid sales laws. The consequences would be devastating. What would the company be worth without its China operation?
Citron challenges the investment banking community to the following exercise. Which of the eight firms providing coverage would be willing to review all the evidence of Nu Skin's illegal operations in China objectively, and redraw their models to:
- Remove all income from China from Nu Skin's P&L
- Write down the assets for capital spent in China to the business net of multi-level sales (which would be near zero)
- e.g. How many customers would walk into a Nu Skin store and walk out with a retail purchase? Would there even be any "Nu Skin stores"?
- Reduce the company's growth trajectory to its realistic prospects with China revenues subtracted
- Project the costs of replacing all management who definitively knew and actively abetted this business development in violation of China's laws ... and ...
- Set a revised price target for the company's stock, to account for the risk to operating an illegal business model.
Is your skin in this game?