Is Wall Street Waking Up To MLM’s Flawed Business Model?
Jun 1, 2012
A Few Questions about One MLM Set off Panic Selling...
A highly unusual event occurred in May, 2012 that drastically affected businesses and individuals who invest in the stocks of multi-level marketing (MLM) companies. A hedge fund manager – who is famous for rigorous research, uncanny insight into future trends and for selling “short” the companies that he thinks are unsustainable – publicly asked a few pointed questions about the MLM company, Herbalife. The mere questioning appears to have triggered a panic sell-off of the stock. The result was a drop in share price of more than 20%. And even though he did not reference it, the stock of a similar MLM company, Nu Skin, also crashed. For individuals and institutions holding Herbalife or Nu Skin stock, this caused huge financial losses and threw many investors and analysts into confusion. Billions of so-called MLM equity vanished. The stocks of both Nu Skin and Herbalife had been high flying, based on “growth” and the companies’ implausible claims of extraordinary consumer demand for their commodity products – weight loss drinks and skin lotions.
The questions by the hedge fund manager notably ignored Herbalife’s products completely. Instead, they probed the business model, asking about the percentage of sales by Herbalife’s distributors to retail customers. In other words, where does Herbalife’s money actually come from, consumers in the open market or internally from those under contract to Herbalife and participating in its pay plan? He also asked about a disclosure in an earlier annual report of percentages of orders placed by segments of the Herbalife sales force, which inexplicably was absent in the latest report.
Loaded Questions
While many investors appear flummoxed by those questions and the ensuing financial collapse, for those familiar with multi-level marketing (MLM), the questions were loaded with meaning and the consequences understandable. For those in-the-know about MLMs the only question might be, how could intelligent and professional people hold large positions in Herbalife stock yet know so little about that business? (At this moment, end of May, 2012, it is not known if the questioning hedge fund manager was among those that owned stock in MLM companies).
In the case of Herbalife, only a few years before a federal judge had ruled that a charge by a group of top-level Herbalife distributors that Herbalife was an illegal pyramid scheme was worthy of a day in court, and the judge spelled out the specific reasons why he felt the charge had merit. More recently, a European court had ruled that Herbalife was an illegal pyramid scheme. Herbalife had also paid out millions also to settle two separate class action lawsuits, both of which charged that the company was a pyramid scheme. The suits claimed that most Herbalife revenue came directly and ultimately from the investments of the salespeople, not from retail sales.
Prosecutions of MLM companies are normally based on whether the MLM businesses are disguised pyramid schemes or not. A key determinant of that question is the level of revenue gained from retail sales. The answer can determine the MLM company’s legality or fraudulence. MLM companies in which the profit of earlier distributors is derived from the payments of later distributors are viewed as “closed market” scams, pyramid schemes. The courts have repeatedly affirmed that there must be adequate retail revenue (outside the sales chain) to cover the internal payments that the MLM companies make to their recruiters. The most recent court affirmation came in a case brought by the Federal Trade Commission against the popular MLM, Burnlounge Inc. The courts have made clear and the FTC itself has based its prosecutions on the rulings that payments to recruiters cannot come directly and ultimately from the new recruits themselves.
The retail revenue issue is not only a crucial legal distinction. It determines the viability of the business model and the marketing program. In those cases where the source of the payments to recruiters is the investments of the later sales recruits, the business model dictates that the only way a new sales recruit could recoup his/her own investment would be to recruit yet more salespeople, who would have to do the same, ad infinitum. This is mathematically and financially impossible. The system is unsustainable. The last ones to join are always financially doomed, i.e., the business practice is unfair. The income claims and promises used to lure new recruits would be false and misleading, i.e., the business practice is deceptive.
The hedge fund manager’s question about how much revenue comes from outside the sales chain – retail revenue – could therefore be interpreted as a stick of dynamite – a question as to whether Herbalife was engaging in “unfair and deceptive trade practices”, that is, whether it is a legal company or not. The followup question about data disclosures addressed the other factor MLMs are consistently accused of – the concealment of massive failure/quitting/loss rates among the newest recruits. Effectively, he appeared to be probing whether Herbalife might be churning thousands of consumers each year and causing large-scale consumer losses while concealing the data.
The sudden sell-off and the resulting investor losses is now a subject of speculation and analysis by the financial media. For the first time ever, business writers are asking about the sustainability and even legality of multi-level marketing. It may be that a Wall Street tipping point was finally reached following SEC subpoenas to the MLM, Pre-Paid Legal and multi-million dollar court judgements against that MLM. It may have included the multi-million dollar settlement payments made by MLM pillars, Herbalife, Amway and Nu Skin, in class action lawsuits in which consumers all made the same pyramid fraud charges. And it have been motivated by the strange volatility of MLM stocks or preposterous MLM product claims about “anti-aging”, or MLM sales of the now FDA-banned “weight loss” substance, ephedrine. Whatever the spark, recent inquiries indicate that, possibly, Wall Street is waking up to the reality of this new American industry, called “multi-level marketing,” and is asking if it might be a gigantic pyramid scheme selling false hopes to Main Street America and making millions off consumer losses.
This question has been raging on Main Street for many years. Wall Street was not paying attention to those claims. It was too busy making money on what MLM called “growth” and “profits.”
The MLM “Industry”
Note: The analysis of this report broadly describes the traits of this still undefined (by Wall Street) industry called multi-level marketing. To understand the workings of any individual MLM company and the degree to which these general traits apply requires research and analysis.
Among publicly traded multi-level marketing companies are Nu Skin (NUS), Herbalife (HLF), Usana (USNA), Avon (AVP), Medifast (MED) (Take Shape for Life Div. that accounts for nearly 60% of business), Mannatech (MTEX), Reliv (RELV) and Your Travel Biz, now called YTB International (YTBLA). Pre-Paid Legal Services, Inc. (PPD) was, until last year, also publicly traded, when it was acquired by a private equity firm. Amway also had two publicly traded subsidiaries in the past, Amway Japan and Amway Asia Pacific. These companies were also later privatized.
Virtually the entire stock value of the MLM, Your Travel Biz.com (YTBLA) was wiped out several years ago after the company was prosecuted by the California Attorney General’s Office for operating an illegal pyramid scheme. To some degree, the fate of YTB is the jeopardy all MLMs face from regulators. YTB, until that prosecution by one state, was high flying and fast growing. It had hundreds of thousands of sales people, celebrity spokesmen, and a stock price that reached $8.50 a share. It had no record of investigations or prosecutions. Currently it trades for $.02, (that’s two cents a share).
Historically, Avon was a traditional direct selling company, basing its revenue upon brand equity, retail customer loyalty, consumer demand, and retail selling. However, in 2005, Avon modified its model to multi-level marketing and now tells shareholders that it “offsets” declining revenue and declining sales per sales representative by recruiting more salespeople (who buy inventory), a classic MLM strategy. Avon is also embroiled in a bribery controversy in China, where the MLM sales model is banned.
The MLM companies noted above have a collective market capitalization of about $15.5 billion. This is indeed big business but as a group of common equities, they have shown extraordinary instability. Just in the last year, all have dropped from high share prices to low by a range of 40-80%. Yet, despite their collective size and volatility, the MLM industry is an information black hole for Wall Street. The sudden plunge in the stock values of MLMs, Herbalife and Nu Skin, that was set off by the simple questions of one major investment house could be the signal that a deeper look into this business is coming.
Investor Ignorance, Fantasy and Cynicism
Publicly traded companies must disclose more information about their operations than private firms do. However, MLM companies, publicly traded or not, are not classified as a distinct business sector by the SEC or by financial analysts. Rather, they are mis-categorized by their respective products (skin lotion, weight loss drinks, laundry soap, vitamin pills, etc.). Consequently, the unique business model and specialized marketing practices of multi-level marketing are seldom examined or understood by investors or by Wall Street analysts. An entire “industry” is getting vast amounts of money from Wall Street investors who have little or no information about that industry. It is also likely that no one inside the U.S. Securities & Exchange Commission (SEC) has a clue how MLM works, and yet that agency is supposed to protect investors from potential industry deception.
Worse than merely not knowing, some financial analysts hold absurdly erroneous and unfounded beliefs about how MLM companies operate. They have no knowledge at all about failure rates of distributors, recruitment rates, churn rates, marketing tactics, income claims, reliance upon recruiting, market saturation factors, cult aspects, training and motivation seminars, or even how the MLM pay plans – the keys to the entire business – work. Many know nothing of MLM’s legal jeopardy or the special regulatory risks they run. They know nothing about who MLM customers are because MLM companies claim they don’t know either! Many analysts and investors maintain fantasies of encyclopedia salesmen, “Avon Ladies” and “Fuller Brush men”, mythic figures that disappeared decades ago and were replaced by aggressive hucksters of “exponential expansion” of salespeople, not door-to-door sales of consumer products.
Some financial analysts who have contacted Pyramid Scheme Alert for insights into MLM have stated baldly that they privately view the MLM industry as a giant scam, but a very profitable one. So they say they will dutifully invest their clients’ funds in MLMs for as long as the government does not prosecute them and the pyramid does not collapse. They point out the ties that MLM companies have to FTC officials, the MLM industry lobbying of Congress and state legislatures and the millions recently given to presidential candidate Mitt Romney by Nu Skin executives. They express cynicism that anything will stop such a profitable and politically connected scam.
Marketing and Business Model Realities
Multi-level marketing companies constitute a distinct new business sector on Wall Street and Main Street. Companies in this industry have a common business model and a common product. The true product of all multi-level marketing companies is a financial product. It is an enticing “income opportunity”. MLM is the only industry, other than gambling and securities, that promises consumers they can make money – a lot of money – if they also buy their products. To gain this income opportunity, the consumer must first buy the right to become a “contractor” for the MLM and to operate a “distributorship.” All consumers who sign up with MLM companies, whether they are at the top or the bottom of the chain, are legally re-defined from consumers to “contractors” and become authorized MLM “distributors.”
The financial product sold by MLMs is the the same for all the companies. The financial product is based upon the consumer/investors paying to join, buying products and then recruiting other investors (salespeople). The universal MLM compensation plan provides for payments to be transferred from a long genealogy of salespeople up to the top of the recruiting chain. As the chain extends and expands, the volume of income flowing to the top grows “exponentially” (2,4,8,16,32,64, etc.). The expansive income from a growing base of recruits is also compounded by the classic “top-loaded” MLM pay formula that actually pays those at the upper level of the chain more than those below who do the actual recruiting, per sale. This is exactly the reverse of conventional direct selling companies that pay the great majority of total commission on each sale to the bottom ranks where the work is actually done.
So the top positions in MLM gain from more recruits in the chain and, as a group, they get more dollars per sale from all recruits in the chain below them. 40-60% of the price of the goods paid by the all the salespeople collectively is transferred to the recruiting chain. The pay formula proscribes that 50-80% of that margin will be transferred directly to the top 1% of the recruitment chain. It does not take a business genius to see that the real income opportunity is based on recruiting more salespeople… to recruit more salespeople… to recruit… not on individual door-to-door sales to retail customers.
The last person to join the chain is sold exactly the same income proposition as the first one was. Market limits and mathematical limits are not accounted for. The MLM company proclaims that the income potential for all new consumers who join is always and forever “unlimited.”
Marketing by the MLM company does not consist of the promotions of its consumer product. Few engage in advertising. Instead, the recruitment of a new consumer-investors constitutes the true “sale” by the MLM company. The only real competitors of MLM companies are, therefore, other MLM companies that are selling exactly the same income scheme, regardless of their consumer product offering. All MLM companies compete with each other in scouring the land for the same recruits. Revealing the common identity of the members of this “industry”, most MLM companies contain “non-compete” clauses in their sales contracts that prohibit all salespeople from participating in other MLMs – regardless of product type – during their tenure. Consumers who sign up are also legally prohibited from recruiting others in the scheme to any other MLMs (regardless of product) for as much as a year or more after quitting.
The sale of consumer products occurs subsequently to recruiting. The purchase of a MLM consumer item by the MLM salespeople is inextricably tied to and is a by-product of their first buying the income opportunity. A product purchase by the salesperson is required or is effectively induced in order for the new recruit to get in on the “income opportunity.” A closer look at these schemes shows that the product could not be sold at near the volume the companies achieve or at the high prices charged without the attachment of MLM’s “unique” and defining income promise.
MLM companies, unlike all conventional businesses, do not need to build brand equity, develop product loyalty, produce superior quality, offer better pricing, or provide convenient availability. In fact, most MLM products are unknown to buyers prior to recruitment, are of commodity value, are higher priced than similar goods and are available only through the narrow and limited MLM channel.
In many cases, the consumer pays money for a MLM product of lesser value than is charged, and in the bargain, often buys consumer goods he/she would not have purchased at all or at that price or at that volume without the exciting promise of income driving and shaping the transaction. When the income promise is unfulfilled, as it will be to virtually all recruits, most consumers quit the scheme within a year and never buy the MLM product again in their lives, thus dispelling any claims that “love of product” was what led them to sign up in the first place.
In the recruitment-based MLM scheme, the “distributorship” that each new recruit buys as an “independent contractor” is actually worthless. Few, if any, make a sustainable income from “distributing” products to the general public. The value is realized only if enough other investor/distributors are brought into the pay scheme. It is those later investments that are transferred to the recruiters and are renamed “income.” In reality, they are merely capital investments transferred from a later group to an earlier one.
MLMs Perpetually Haunted by Government Crackdown
When the MLM income claims are revealed to be false or misleading, or when they are shown to be dependent upon “endless chain” recruiting, the MLM may be subject to prosecution for operating a pyramid scheme. Prosecutions have devastating consequences for the company and its shareholders, as the experience of the MLM, Your Travel Business, revealed.
When brought by the US Federal Trade Commission (FTC), prosecutions are done under Section 5 of the FTC Act, against “unfair and deceptive trade practices.” When states bring charges, they usually cite their own state statutes against pyramid schemes or deceptive sales.
MLMs, therefore, are unique in the business world by their potential for being regulated out of existence. What is at stake is not exposure of financial abuse or excesses, but rather the legitimacy of the business model itself. The regulatory threat is not directed at the MLM products, pricing, advertising or financing, though all may be deceptive, but rather at the driver of the company’s revenue, the defining MLM pay plan.
Selling an income promise that is based on recruiting other investors who must do the same, etc., requires extensive deceit because such a plan cannot sustain itself. Since the schemes are constantly recruiting more than half their entire sales forces each year, such a model causes financial losses to 99% of all the “distributors.” All those who lose and quit must constantly be replaced. MLMs are in a never-ending and existential hunt all over the globe for new recruits. Effectively, they collapse each year, as the majority of their purchasing sales representatives “fail” and quit, and then the MLMs resurrect themselves with the investment capital of fresh recruits.
Defense, Diversion and Disguise
To protect themselves from prosecution or exposure, MLM companies put forth an elaborate fiction of “direct selling” to disguise the core business of pyramid recruiting. As defensive measures, a massive PR program and a world-class lobbying campaign are conducted by the MLM industry to convince consumers that the pay/buy/recruit model is valid, and lucrative for all and to persuade regulators to look the other way. It’s all about the products, the companies claim. Yet, consumers routinely report attending recruitment meetings in which the MLM product is barely referenced or is said to “sell itself.” The real business, they say, was about recruiting more salespeople. The low profit margins on retail sales, the lack of marketing support and the high costs of finding and selling to retail customers make retail sales financially unfeasible. And how could retailing be profitable when the company continues to generate more and more retailers, all of whom are competitors for retail customers, in each geographic area?
Ten-Point Portrait of the MLM Industry
To summarize the distinct factors that characterize and define multi-level marketing companies:
1. Payment Required for Participating in “infinitely expanding” income opportunity. The pay plan offered to consumers is based upon the consumer enrolling as a salesperson and recruiting and profiting from the purchases and other salespeople. The income opportunity requires payment of a fee or starter-kit purchase to qualify.
2. Ongoing purchase/sales requirements for qualifying or maintaining levels of commissions assigned to each level of the sales chain.
3. Low level of profitable retail income per sales person; in some cases, virtually no retail revenue at all; and virtually no salespeople making net profits from retailing alone; virtually all the income of the company comes only and ultimately from the salespeople themselves.
4. Laden with Levels: The “sales” organization has multiple levels unrelated to actual management or distribution needs. The multiple levels and “ranks” serve no sales or management purpose but are functionally required to leverage the pyramid recruitment program, 5,25,125,625, etc.
5. Top-Loaded Pay: The pay plan, by commission schedule and by policy, transfers a higher percentage of reward on each sale to top levels of the chain than it does to the lower levels that are closest to the transaction and expended the most marketing effort and cost.
6. What the schemes sell in the open market is a “business opportunity”, not the advertised consumer products such as “pills, potions and lotions.” Products are not sold on the open market. Product “sales” are mostly internal transactions between the company and its own contractors or between and among the contractors; product purchases follow the recruiting transactions; sales volume depends directly upon recruitment levels. The essential and primary driver of “sales” is the income promise. Without it, the company would collapse immediately.
7. MLMs do not compete with other companies selling similar consumer goods in the open market. Since their main customers are those inside a closed network, the MLM company can charge far higher prices to its “members” based on intangible or promised benefits. The MLM company has little need for “customer service” because it has few repeat customers and it has no need to advertise or develop brand identity since it is not marketing products openly.
8. MLM companies are not affected by the laws of supply and demand – for their products. Their real product of an income opportunity is “limitless”, based on a claim of “endless” recruiting that can produce “unlimited” profits. When markets for their consumer products decline, as in an Economic Recession, the market for MLMs’ true product, an “extraordinary” income opportunity, rises along with unemployment, misery and desperation. Even if the weight loss or cosmetic markets, for example, retract, the MLM sales of those types of products may expand.
9. Similarly, MLM companies are not affected by market prices. Once inside the pay plan, few consumers will do comparison pricing of the MLM goods because they are buying an income opportunity, not just the product itself. Ordinary products, that cannot offer “income” are not “comparable.” Even if the MLM offers a competitive price for their products, they can also add many buying costs such as sign-up fees, renewal fees, training assessments, conference registrations, and “back-office” charges. Most also charge high shipping fees and sales taxes based on a higher price than the sales representative actually paid.
10. Magical Products: The MLM products are famous for being promoted as “unique”, groundbreaking, patented and “not available in stores.” They are often promoted as having nearly magical properties. They are said to be tickets to high income and can “sell themselves.” Often they are claimed to cure every ailment from autism to AIDS, to halt the aging process or to ward off cancer, though the fine print says that distributors can claim no therapeutic value at all.
MLM Pitfalls
Though the MLM model was impervious to economic and market factors that all legitimate business adapted to, there are three specific factors that affected MLM businesses negatively:
-
Regulatory action against fraudulent or false product claims, misleading income testimonials or illegal pyramid operation. Previously, law enforcement was a major threat to MLM companies. But, in recent years, regulation has become neglected and corrupted. Some FTC officials in Washington have become lobbyists for MLMs. Others came to the FTC from working for MLM companies. The record of the FTC shows that significant regulation virutally ceased in 2000. Some state regulators have privately reported to Pyramid Scheme Alert that some MLMs are simply too large for them to prosecute in their states. The state regulators say they don’t have enough money or manpower, and they are inhibited by some state legislators that are financially on the take from MLM companies.
-
Exposure and Scrutiny by fraud analysts, whistle-blowers, consumer protection groups, investigative journalists, or class action lawsuits. These actions have had effect but they are not sustained well over time. Factual information and analyses are dwarfed by MLM PR and dis-information.
-
Incompetence: Some MLM schemes decline or fail due to failure to expand to new territories as market saturation sets in, financial or operational mismanagement, under-capitalization, computer flaws, or by major defections of their top recruiters to other MLM schemes offering better rewards to recruiters. The failed MLMs are substantively no different from the successful ones in business model or in types of products or marketing tactics. Failure has nothing to do with product demand. Failure is internal and not driven by conventional market or economic forces because MLMs do not participate in the open market for product sales.
Possible New Force
Today, a fourth factor has emerged that could drastically affect the fortunes of MLM companies. It is the scrutiny of investors and business analysts. It appears that the securities industry is beginning to focus on this sector. To date, no investment fund has developed a comprehensive analysis or challenged MLM companies to produce valid information about their actual operations. The securities industry, on behalf of shareholders, could begin – even if regulators will not – to demand that MLM schemes fully disclose their actual operations, including:
— Retail sales levels and actual average incomes of distributors based on retailing (to show whether they are in the direct selling business or not).
— Churn rate of distributors (who turn out to be the real “customers”). This would reveal market potential and market saturation rates. It would also shed light on whether “customer loyalty” and “demand for product” were driving sales or sales were gained by “channel stuffing”, which is normally viewed as fraudulent.
— Defections of top recruiters. Since all revenue volume is based on recruitment levels, revelations of defections by top level recruiters reveals threats to future volume more so than any other market factor.
— Historic data on distributors in a given geographic are. If investors knew how many consumers were – or ever have been – signed up in a market area, they could determine true market potential and could measure the factor of market saturation, which the MLMs currently conceal. Cumulative recruitment data would provide transparency on the company’s true product and actual mission – the sale of an endless chain income promise – and its actual financial consequences for the public.
If these facts were revealed, investor confidence might become quite difficult to sustain.