Herbalife: Who's Consuming All Those Shakes? And Why...

| About: Herbalife Ltd. (HLF)

Summary

On the ground investigative research into Herbalife's nutrition clubs suggests they're not what they seem.

Club 100's quota system raises questions about the true nature of shake consumption.

The motivation for sales in an MLM matters per recent rulings; that could be a factor in considering Herbalife's business.

What's the truth behind Herbalife's Nutrition Club business? If you read this recent Reuters article, based on interviews the reporters did with people they encountered at ten Nutrition Clubs, you probably came away believing these Clubs are a force for good in the Hispanic community. I think the reporters were deceived by what they saw and heard, and I base this statement on several years of researching these Clubs, not just in the U.S. and Puerto Rico, but Mexico, Colombia, Venezuela and Brazil. Walk into an Herbalife Nutrition Club and you enter into a charade created by an elaborate and cynical "training" system that turns distributors and their family members and friends into conscripted consumers. Let me explain how I came to that conclusion.

I started visiting Herbalife Nutrition Clubs in 2011 as part of a project on behalf of a number of hedge fund managers who were trying to determine whether Herbalife Ltd. (NYSE:HLF) was a legitimate business or, as some critics alleged, a pyramid scheme: an unsustainable and illegal business model in which participants make money primarily by enrolling new participants in the business.

To help answer this question, I decided to take a close look at Herbalife's Nutrition Club network, which was (and still is) fueling the company's growth. These Clubs, which serve single portions of the company's products such as its Formula One protein shake, were popular with a surprising demographic in the U.S.: Hispanic immigrants in low-income neighborhoods.

I started my research by visiting the Corona neighborhood of Queens, mapping out the Clubs surrounding Junction Boulevard and Roosevelt Avenue. Many were hidden away in undesirable retail locations, down alleys and in the basement level of strip malls, with shabby looking storefronts and interiors hidden by green curtains. A handful, however, were more prominent and had signs (in Spanish) that expressed boundless optimism: "A Beautiful Life," "A Better World," etc. But one thing I knew for sure was that there were far too many of these Clubs to make any economic sense: I found 26 within a few blocks of the Junction Boulevard subway stop.

Shortly after, I started visiting Nutrition Clubs with hedge fund clients. Herbalife was under no particular scrutiny then, which was a good thing, because we certainly didn't blend in at the largely Ecuadorean-run Clubs we were visiting: a middle-aged white woman, with a notebook and a printed Google map of the neighborhood, and a hedge fund analyst, invariably "dressed down" in baseball cap and extraordinarily expensive loafers. We stood out like two Jehovah's Witnesses canvassing the neighborhood - and that was before we opened our mouths. On one of my first visits with an analyst, I warned him that my high school Spanish was a bit rusty and asked if he spoke any. Alas, he replied that he had studied Latin in school.

During our visits, we identified ourselves as analysts seeking to better understand the operations of this publicly traded company. I think most people suspected we were from Herbalife's compliance department, checking to see whether they were following the company's endless and often bizarre rules: no Herbalife signs visible from the street, all doors and windows covered to prevent visibility into the Club, no "Open" or "Closed" signs, no selling full containers of products, etc. (These rules alone raised serious doubts in my mind about how a distributor could hope to succeed.)

The people we met in the Clubs were without exception friendly and tolerant of the communication barrier. They believed Herbalife was transforming their lives from paid-under-the-table kitchen help and construction workers into full-fledged achievers of the American Dream. They talked about Nutrition Clubs as a route to the prestigious and lucrative Herbalife "President's Team." I left every Club I visited hoping that somehow this business would work out for them.

Many people dismiss the harm done by pyramid schemes, downplaying it with comparisons to companies that sell us things that aren't very good for us: cigarettes and liquor, fast food and lottery tickets, etc. But this is a spurious comparison. Nobody who smokes thinks it's good for them and nobody who buys a lottery ticket thinks the odds are in their favor.

Meanwhile, deceptive business opportunities reshape lives around lies, making deep inroads into a person's psyche, changing whom they interact with and whom they shut out, how they spend their waking hours, and how they dream about and build for their future. Robert Fitzpatrick, an expert in analyzing business opportunity fraud, had concluded that Herbalife's business was based on deception long before I began my research. He summed it up in an email he sent me: "Herbalife has entered the fabric of Main Street. It has tampered with the souls of millions of people."

So, what was Herbalife doing with these souls in this hardworking, immigrant community in Queens? Was it delivering on its promise of a better life for the people who attended and ran these Clubs? If so, there was something extraordinary at work here: a company that had found a way to engage those at the bottom of the economic ladder, people confronted with daily hardships most Americans can only imagine, and through its products and business opportunity was steering them toward better health and financial security.

For some, Herbalife clearly hadn't delivered on this promise, as evidenced by the dozens of shuttered or moribund Nutrition Clubs I saw, testaments to someone's failed dream - and to my suspicion that these Clubs were a place for disillusioned (and broke) Herbalife distributors to dump the product they'd been forced to buy in their pursuit of the "business opportunity."

But I also found active Clubs and watched as people came through the door, handed over $5, and drank servings of the products. I watched Club operators record each person's name and proudly explain that these customers came each and every day - they were frequently described as "socios" (the Spanish word for partner) in this grand Herbalife vision of health and financial freedom. Yet, there was always a hint of staging to these interactions. More than once I asked a person visiting a Club if he or she worked there or was an Herbalife distributor, and the answer, from a person with a limited English vocabulary, was jarring: "No. I just come here to consume." Consume?

One morning I visited a number of Clubs with a well-known hedge fund manager -- a positive sign that interest in our research was trickling upward. Hedge fund types tend to be health and body conscious and while most were curious to see the products, they baulked at actually consuming them. "You can never be too careful about what you put into your body." This meant that when the host's back was turned, I frequently switched the cups and ended up drinking both servings. But, on this day, my companion was 100% into the research; he gamely consumed at every club and complimented the host on the preparation. Among the Clubs we visited was one enthusiastically staffed by a husband and wife team, who phoned their high school-age son to come and translate. All three were distributors and had put the family savings, plus money borrowed from relatives, into the Club.

On our final stop, we climbed a creaky flight of stairs to the second floor where -- expecting to find a locked door or a deserted Club -- we entered a tiny room in which about a dozen men in bulky hoodies and heavy work boots sat silently on folding chairs, eyes fixed straight ahead, Formula One shakes in hand. These men were vaguely familiar, the faces one glimpses hauling debris out of buildings undergoing renovations, bussing dishes in the kitchens of restaurants, and flying through treacherous Manhattan traffic on rickety bicycles, delivering food. They certainly weren't overweight and didn't appear to have the luxury of the time or money required to consume expensive nutritional shakes in a Club. But nevertheless, here they were, doing what Herbalife claimed so many in the Hispanic community loved to do: gather in a social setting to enjoy good nutrition.

The host had a bright - though slightly bemused - smile for us. Everyone else could have been waiting for a bus; oblivious to a cartoon blasting in Spanish on an overhead TV, the men ignored one another and avoided eye contact with us.

With every seat taken, we had to stand, drinking our third Formula One shake, Aloe Water and Herbal Tea of the morning, a good 40 to 50 fluid ounces each into our research. A few minutes later, in search of the bathroom, we were directed into a large adjoining room where, the host explained, the group held regular training meetings. It was empty, lights out, but he assured us that it filled up twice a week with all of the distributors in the neighborhood who were learning the business.

On our way back down the stairs, I asked my companion if he thought people were really there because they wanted to drink a Formula One shake.

"No."

So what were they doing?

Herbalife claims that Nutrition Club visitors are genuine customers seeking better health and are drawn to the Clubs because they lack the economic resources to buy an entire container of Formula One, so instead they're paying a few dollars a day to consume single portions of the products. These consumers prove that Herbalife is not a pyramid scheme, according to the company, because, after all, if the sales in Nutrition Clubs are to real customers, then the commissions Herbalife pays on the purchase of those products to the distributors operating the Clubs are linked primarily to retail sales, not to recruitment and qualification.

Were these men grudgingly consuming shakes in a tiny Club in Queens examples of the customers that proved Herbalife was not a pyramid scheme?

The answer only became clear later, when I was hired full-time to study Herbalife by another hedge fund manager, Bill Ackman, whom I met as a reporter covering his short position on a bond insurance company called MBIA. That was a seven-year story, and you can read a book about it here. MBIA, which insured bonds backed by risky mortgages and magically turned them into triple-A-rated securities in the run-up to the 2008 credit crisis, was a company that, like Herbalife, one might argue was in the too-good-to-be-true business.

Soon after I began work for Ackman, I came across the first "Club 100" Nutrition Club on the Internet. The group, also known by its Spanish name "Club Cien," appeared to make up a vast network of Herbalife Nutrition Clubs in the Hispanic community in the U.S. and across Latin America. I found a Yahoo message board used by Club 100 members in Venezuela describing the rules for visiting an Herbalife Nutrition Club.

Rules for customers?

I ran parts of the text through Google Translate and out spilled a cryptic and clunky description of how a person visiting a Club is supposed to act:

"AVOID MAJOR GROUPS OF 5 PEOPLE BY CLUB TO VISIT."

"AVOID THE USE OF UNAUTHORIZED PHOTO CAMERAS."

"AVOID TALKING TO CONSUMERS CLUB, UNLESS YOU ASK THE HOST."

"CAN BE VIEWED ONLY CLUBS THAT ARE 25 AND MORE ACTIVE IN THE SYSTEM CERTIFICATION WITH SEALS."

"REMEMBER THE RULE: ALWAYS GOOD ATTITUDE: SILENT, KIND, ASSIGN CONSUMERS CHAIRS. IF TESTIMONY TO HELP AND GIVE WHAT YOU ASK, SEEK TO AVOID SPECIFIC PRODUCTS OR FLAVORS , WITH QUESTIONS TO AVOID HOST STOP OR WHILE STUDENTS ARE RESPONDING TO CONSUMERS."

It was stunning.

Since when are real customers told to remain silent and instructed not to ask for certain flavors? But, if the people visiting Nutrition Clubs weren't real customers, who were they?

To find out, we hired freelance reporters and private investigators to visit Club 100 Clubs in major cities in the U.S. and Puerto Rico, then in Mexico, Colombia, Venezuela and Brazil. There was a great deal of secrecy surrounding Club 100's business methods. We were often told that only those who signed up with Herbalife through Club 100 were allowed to know how the plan operated. Even those already enrolled in the group were kept in the dark about much of its operation and were told they would be informed about the next phase only after completing the current phase. We signed up and joined Club 100 agreeing to do exactly what we were told was necessary to succeed. Our investigators uncovered a business that turns those seeking to open Nutrition Clubs - along with family members and friends helping them pursue their dream - into conscripted consumers by forcing aspiring Club owners through a series of tasks: touring Clubs and paying to consume at each one, working for free in an upline distributor's Club while being required to consume on the job, and practicing making hundreds of shakes, which family members are required to buy and consume. Trainees also are required to create a story or testimonial about the benefits of the products on their health and to tell this story numerous times to potential recruits in order to graduate. Only those who complete all these tasks, which are tracked and verified by upline distributors on an official form, are certified to open their own Clubs.

The promised rewards are enticing. Those who follow Club 100's rules are told they will reach the President's Team where they can expect to earn hundreds of thousands of dollars a year for the rest of their lives. Herbalife's own data suggests that fewer than 1-in-10,000 distributors will reach the President's Team - but these nearly impossible odds are rarely if ever disclosed to recruits.

Instead, Herbalife trainers (i.e. recruiters) play on desperation and disappointment. In the U.S. we recorded training sessions where messages like the following were directed at undocumented workers for whom the American Dream had proved elusive:

"If you take it (the certification course), you'll get good consequences. If you leave it, I don't know how life will go for you, because how long have you been in this country? 10? 15? 20 years? Another 5, 10 or 20 years will go by and you'll continue in the same spot. Because if in another 5 or 10 years you haven't achieved what you expected in this country, you're not going to achieve it."

On July 22, 2014, as part of Bill Ackman's presentation on Herbalife entitled "The Big Lie," I detailed our findings about Club 100. While investors appear to have mostly ignored our findings - on the company's second quarter earnings conference call a few days later, not a single analyst asked about Club 100 - I believe it is key to understanding the character of Herbalife's business, and, ultimately to forecasting the company's fate.

Herbalife aggressively sells its "business opportunity" - but requires lots of coerced consuming to access it. Our team's months of research in the U.S., Puerto Rico, Mexico, Colombia and Venezuela showed that a distributor diligently attempting the certification process - the first step in Club 100's complex and secretive plan - would consume or cause other people to consume about 632 shakes over a three-month period. Here's how:

Trainees are expected to work out of an upline distributor's Club. As part of this unpaid internship, they are expected to consume as often as twice a day - AM and PM shifts.

180 Shakes Consumed

Trainees are required to go on tours of eight Nutrition Clubs and to pay for and consume at each Club.

8

Shakes Consumed

Trainees are often expected to consume at classes and other mandatory events. Let's assume a trainee attends three weekly events for 12 weeks.

36 Shakes Consumed

Trainees are required to make 100 shakes as part of the mandatory shake training requirement. Distributors are likely to offer free samples (which they pay for) or cajole friends and family members to come into the Club to pay for and consume these practice shakes.

100 Shakes Consumed

Trainees are required to take a test proving they can invite one paying consumer into a Club every half hour for four hours

8 Shakes Consumed

Trainees are expected to recruit 10 individuals who will act as regular attendees of an upline distributor's Club for one month.

300 Shakes Consumed

Total Shakes Consumed

632*

*The actual numbers vary quite a bit because there is plenty of room for trainers to impose inconsistent and repetitive requirements, but I believe these estimates are realistic.

That averages out to seven shakes every single day for every single recruit (632 / 90 days), which adds up to millions of shakes annually! Again, if all this consumption was legitimate, Herbalife would be a reputable and impressive business. But it's not - it's part of a nefarious plan to bring low-income distributors (and their friends and family) into Clubs to share the cost of admission to this deceptively promoted American Dream.

Some claim that the motivation of these customers doesn't matter - consumption is consumption. But the courts and regulators see it differently.

Since the beginning of this Wall Street battle, the Direct Selling Association, which represents Herbalife and other MLMs, has pointed reporters and analysts interested in evaluating whether Herbalife is a pyramid scheme to a 2004 advisory letter issued by the FTC on the question of distributor consumption, which states: "Much has been made of the personal, or internal, consumption issue in recent years. In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme."

Herbalife has leaned heavily on this letter and, in fact, the company now calls its distributors "members."

Yet, on June 2, 2014, an appeals panel upheld a decision that BurnLounge, an MLM that sold downloadable music, was a pyramid scheme. BurnLounge had appealed an earlier ruling, in part, by citing the 2004 letter and arguing that its distributors should be considered customers. The court rejected the argument and pointed back to the 2004 letter, stressing that the relevant passage on internal consumption must be read in its entirety: "The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture."

In other words, motivation does, in fact, matter. Regulators and courts want to know why people are consuming a product. Are they consuming it because they like it and would choose it over other products based on price, quality, brand, the overall experience, etc.? Or, is the real motivation behind the purchase of a product "the right to participate in a money-making venture"?

The Club 100 system is fiendishly clever. It ensnares countless people all over the world in Herbalife's web, drains them of their time and money and, best of all (from Herbalife's point of view), results in a great deal of consumption of Herbalife's products, which makes it much harder for regulators to detect and shut down this sophisticated pyramid scheme. Finally, it is clear why we don't see very much Herbalife product stacked in garages or dumped on eBay, and why so little is returned to the company. Most of the product is indeed consumed, but not, as Herbalife would have you believe, by real customers but rather by those pursuing quotas established by the company's top distributors for people they deceive into pursuing a false promise of the American Dream.

Shut out by language and cultural barriers, by suspicion that we were compliance officers or immigration officials posing as Wall Street researchers, and, most importantly, by a system that created its own illusion, it would be three years before I understood it. Now, thinking back on that morning in Queens, I understand why the men crowded into that second-story Nutrition Club in Queens appeared to be such unconvincing customers - it's because they weren't real customers. Instead, they were spending money they couldn't spare to drink a shake they probably didn't like to lose fat they didn't have in order to pursue (or help a friend or family member pursue) a "certification" for a "business opportunity" that doesn't exist for the overwhelming majority of people. They weren't customers in any traditional sense of the word; rather, they were paying the price of admission to a fraudulently promoted business, one shake at a time.

Christine Richard is the President of Orion Research LLC, which does investigative research for investors. She is a former reporter with Bloomberg News and Dow Jones and the author of Confidence Game: How Bill Ackman Called Wall Street's Bluff (Wiley, 2010). Pershing Square Capital Management, which has a short position on Herbalife, is a client of Orion Research LLC.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: The author does not take positions in companies she researches. Pershing Square Capital Management, which has a short position on Herbalife, is a client of Orion Research LLC.

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