Now that the dust has settled from the Vemma ruling and we have discussed why a negative FTC ruling does not hurt Herbalife (NYSE:HLF), let us look at why HLF is not in the same kind of trouble with the FTC as Vemma and why the company is not a dangerous pyramid scheme.
Vemma was putting a strong emphasis on selling $500+ starter kits and teaching its recruits how to sell starter kits to others as a way to recoup its costs. A major emphasis was put on these sales to new recruits to the business plan.
Herbalife's starter kits cost less than $100. No big money involved. No big profits for distributors. No pyramid scheme. Now that we have dealt with the Vemma comparison, what's next?
Shorts such as Bill Ackman make a big deal about the disclosure of retail sales and how members who are customers buying at a discount are not really customers. This should come as a surprise to Costco (NASDAQ:COST) and most state tax authorities.
Costco charges a membership fee and allows members to buy products at a discount. You have to be a member to enter the store and get these discounts. Members are charged sales tax on their purchases unless they have registered as wholesalers and provided the proper licensing documentation.
Herbalife sells a small amount of product to a new member for less than the cost of a Costco membership. The new member can now buy products in the future at a discount. Just like Costco, you have to be a member to get the discount. Unless the new member registers with Herbalife as a wholesale purchaser by providing proper licensing documentation, HLF has to charge the member sales tax.
Sales tax is the key. By definition, if sales tax is charged, a retail sale has taken place. The state taxing authorities don't care if the buyer is a member or non-member. In network or out of network does not matter. The authorities don't care if the product was sold at MSRP or at a 50% discount. All that the authorities care about is that the sale took place to someone who is not a licensed reseller.
If a member is not a reseller, sales tax is paid. If sales is paid, it is a retail sale to an end user. This is all based on state laws and has nothing to do with the FTC or Federal Courts. Most states with a sales tax are going to require Herbalife to pay sales taxes because it has distributors in the state selling products.
Herbalife naysayers love to talk about how difficult it is for distributors to make money because of pricing competition where few people are selling the products for MSRP. Well, welcome to the real world of retail. How many products are there that actually sell at the MSRP? Almost none. How many consumers happily pay the MSRP for products and don't look for pricing deals? Almost none. Who makes big business out of not selling at MSRP? Costco, Wal-Mart (NYSE:WMT), Target (NYSE:TGT), Kohl's (NYSE:KSS)...
Nutritional supplements are heavily discounted in both physical stores and on the Internet. You have to make a conscious choice not to buy at a discount because discounts of 10% to 60% are so easy to find. Even high-priced stores like Whole Foods (WFM) sells many supplements below MSRP.
Yes, discounting makes it difficult to make retail profits without adding some type of extra value to the sale that justifies full retail pricing. This is true in any retail business, not just Herbalife.
The step above retail sales and signing up new members to buy products directly from the company requires distributors to find people like themselves who want to be involved in the business. The frequently vilified process known as recruiting. This does not have to be a shady process. The process is very similar to a sales manager who knows how to sell recruiting sales people.
MLM works this process in layers that bear some resemblance to the structure of a large sales organization. If you want to move up, you need to become a sales manager who trains sales managers. A position very similar to that of a district sales manager.
If you want to move up even further, you need to become a sales manager who trains sales managers who train sales managers. Similar to being a regional sales manager.
I once worked for a reputable national financial firm that had a structure just like this. I received 70% of the commissions including bonuses with the remaining 30% going to pay 4 levels of sales management above me who also split the portion of the commissions that was available to pay bonuses to people who did not qualify for a bonus.
Sounds a lot like an up-line. Managers made all their income off the work of recruits. Very legal and still in existence 30 years later.
The big difference with MLM is that the lowest level members can do recruiting. Anybody can give the business a try. Anybody can get started with a small investment. There is no screening process. Since there is no screening process, there will be many people who try out the business that just do not have the skills or work ethic it takes to be successful. But shouldn't they have the right to try?
Sure, there were often abuses in the MLM industry and still some companies that are abusive today. Lies about how easy it is to get rich quick are more difficult with most companies like Herbalife issuing disclosure documents that show how few people actually make any significant money.
The people becoming distributors are adults. If they read the disclosure documents and think they can be successful, they have a right to give it a try. Mean income in the US is slightly under $43,000, which means half the people make even less. The chance to start a small business for under $100 that might generate a couple hundred to a thousand dollars a month is a good opportunity.
Will they all be successful? No. Do they have the right to try? Yes. Most new businesses do not succeed and most of these businesses require a much greater capital investment.
The business world is full of people who tried their hand at MLM and took their experience to move on to a better job or created their own businesses. During the 1960s through 80s, Mary Kay, Avon (NYSE:AVP) and Tupperware (NYSE:TUP) provided business training to thousands of women who never would have been given a chance by the regular business world.
Success in MLM or any business is seldom easy. If it was, the mean income level would be $1,000,000.
Now that Herbalife promises to buy back all unsold products without charging shipping, the company can no longer be accused of encouraging front-end loading. If a distributor chooses to purchase extra inventory up front for the purpose of obtaining better pricing and it does not work out, they can get all their money back.
This is a better deal than in a standard retail business. A regular retail business generally cannot return unsold inventory to a distributor or manufacturer. Herbalife has also made qualifying for volume discounts accumulative. People who just want to test the business can get better prices as they become successful without having to buy extra product. A handy benefit to people without the capital to get started. Try starting a retail vitamin business without a large upfront outlay for inventory.
None of these issues that Herbalife critics such as Bill Ackman make a big deal about are actually big deals. There is nothing here for the FTC to clamp down on. Sure, there are past issues, but those are past issues. HLF under Michael Johnson has been steadily cleaning up the company to a point where its practices are among the best in the industry. Better than many non-MLM companies.
The government should create some defined standards for the MLM industry, and the current setup of Herbalife is pretty close to what those standards should be. The most that is left for Mr. Johnson to do is a little bit stronger oversight looking for the rogue distributors that might still be around.
There is nothing in the current company set-up under the current regulatory and legal frameworks for the FTC to rule against. The government is very unlikely to create any new rules anytime soon.
The SEC does have some jurisdiction over pyramid investment schemes, but this is not one of them. The SEC's time would be better spent taking a hard look at how activist investors use PR and social media to manipulate the markets. There is no smoking gun that justifies an aggressive short position.
Be prepared to go long when the FTC finally goes away or possibly take a position in call options now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.