E Herbalife: Yes, Alice, There Is A Santa Claus

Personally, I am finding in my local community in the Bronx that the level of fatigue, disenchantment and disgust with the persistent lack of prosecutions and enforcement actions are mounting. In a community with many ethnicities, the evidence of affinity fraud is unmistakable, and when one of these MLM hurricanes passes through, you are left whole groups of people who collectively lose prodigious amounts of money.

Hiding behind the law

While the government has not helped by continuing to foster the fallacy that there is such a thing as a "legitimate MLM," even though the things MLMs do are illegal, the companies, Herbalife included, are doing their own thing, pretending to be legal as long as they have not been prosecuted. In the memorable words of John DeSimone, they have full confidence in their business model, even though it was only theoretically legitimized by the Amway case in '79, because de facto MLM companies, Herbalife included are not living up to the requirements, particularly the 10 customer rule, for the simple reason that their business models are designed for recruiting, not retailing.

For the everyday person, and Herbalife's prospective customers, it remains a confusing situation, and the persistent lack of enforcement has seemed to legitimize obviously illegal business practices. MLM is designed to recruit, and there is no such thing (stipulated in the Bostick settlement) as "discouraging recruiting." Limitless recruiting is the DNA of MLM, that is where the money is, and it inevitably results in too many retail distributors chasing a dwindling prospect set, resulting in disappearing retail margins, or even outright giving away of product as free samples to try and recruit people (see below).

Then there is currently a new wave of new MLMs that are attacking the advance fee fraud feature of MLM, and making it seem as if removing that element solves the problem. I myself thought for a long time that this model had to be legal because it seemed totally innocuous. After all, how can you lose the money you don't invest? But the truth is that the constant income misrepresentations that are used to promote these schemes induce people to over-invest time, effort, money and their good name.

The extra fees that some of them charge just add insult to injury, and are a cheap way of financing that does an end-run around the securities laws, and perhaps franchise laws. After all, if you know statistically that 9 out of 10 people will quit, even in the case of Herbalife with merely a $59 to $95 cost to join, the company raises $600 to $1,000 up front or every "successful" member (who stays at least one year). In the current quarter Herbalife's attrition was 100%. Some companies have $500 to $1,500 of first year fees, or even more. This gives a graphic insight into an industry that thrives on the losses of others that are extracted under false pretenses. Bill Ackman's use of the term "predator" for Michael Johnson was well chosen, and it is true of all MLM, not just Herbalife.

Part of the changes in the industry is that free "preferred customer" programs are becoming the norm, and Herbalife's method of signing everyone up as a distributor for $59 or $95, and then simply treating the 70+% of inactives as discount buyers, and re-labeling them as "members," not distributors, even if they have paid the fee and signed the agreement, appears dubious going forward. Regulators may take issue, but also, their existing or prospective distributors could move to other programs that offer these free preferred customers programs.

In short, for a business that makes such a big deal about being "legal," it is very interesting to note that so many companies make such an effort to hide their MLM-nature. They are "not like Amway," "not like that company where you can't say the name" (still Amway), "not one of them pyramids," an "affiliate company" (Vemma), or even "a product broker" (MarketAmerica), "not like that last company (fill in the most recent case) that was shut down," or even "not MLM" - anything to continue the same thing by a different name while deflecting the negative image of MLM.

Profits from failure as the epidemic rages on
The sad fact is that the constant churn of distributors is not just a financial statistic (this quarter 540K coming and going, for a net growth of zero), but actually a clue to the fact that the company makes money from failure, which alone dooms the company itself to failure in the end. Interestingly, in a recent article on Herbalife competitor Vemma in Rolling Stone, one of the "leaders" in that business says exactly that: "People have to fail for us to make a profit."

Kay Herbert has proposed an epidemological model to understand the "pop and drop" phenomenon of MLM, and not only does this explain why most people lose money, but also why in the end companies are unstable and burn out. Granted, the Amways of the world have managed to hang in there for a long time, but the trend of MLMs to sell more and more products is not sustainable. There is no future in which we're all paying three or four times as much for our groceries for no reason. 

What makes detection harder, and allows the casual observer to think that MLM companies are real businesses, is that there is not just one "pop and drop," but many, depending on the number of products and markets that can foster the illusion of a viable business. Think of the "drop" and the "pop" of Anthony Powell moving from Herbalife to Vemma, bringing in up to 16,000 of his HLF downline. And there was another big player in Malaysia doing the same this year, moving from Herbalife to some other company. All of which led me to an earlier observation of the widely dispersed pattern of gradual failure in MLM, which I labeled the "fractal nature of failure." In short, the end is a scorched earth situation, similar to over-fishing, for the recruiting incentives drive sales to levels far above what is sustainable, until at least some people start to realize they are losing money and begin to quit. Moreover, the sheer number of MLM companies are adding to MLM-fatigue in the population.

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Disclosure: The author has no position long or short, nor intends to open one in the near future.

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Old Time Investor 6 years ago Member's comment

Thanks Rogier, do you have any updates on this stock?

Danny Straus 6 years ago Member's comment

Great read!

John Fitch 6 years ago Member's comment

Great read Rogier. Interesting tidbit, Icahn's investment fund lost 5.3% in the third quarter. Icahn is Herbalife's biggest shareholder. Interested to see the share price if/when Icahn starts to pull out.