The DNA of the MLM Business Model

Herbalife has been making headlines frequently over the past year now, ever since last December when Bill Ackman publicly announced that the California-based multi-level marketing company was a pyramid scheme and unveiled that his hedge fund, Pershing Square Capital Management LP, had taken a large short position. Since then numerous important events have happened including Billionaires Carl Icahn, George Soros and Daniel Loeb taking long positions, Herbalife’s auditor caught with insider trading and subsequently resigning and the Herbalife stock price soaring over 200%.

Herbalife Stock

Source: Bloomberg

There are many multi-level marketing companies out there and they often receive accusations of harboring a pyramid scheme.

So what is really going on at Herbalife and other multi-level marketing companies? If you examine the DNA of multi-level marketing companies, you can see that most are inherently designed to (whether intentionally or not) evolve into a pyramid scheme. Let’s take a closer look…

Understanding Mutli-Level Marketing

Mutli-level marketing companies operate through a network of independent distributors which typically act as the company’s sole sales force. The business model is quite a unique one; they have independent distributors (not directly employed by the company) approach friends and family to sell to. In one hand the independent distributor offers a product, (nutrition supplements in Herbalife’s case) and in the other hand they offer a business opportunity (to become a fellow independent distributor).

How does it become a pyramid scheme?

The following factors, that are deeply embedded within most multi-level marketing companies’ corporate structure and strategy, outline how multi-level marketing companies severely disadvantage themselves in selling their product. Whether it is intentional or not, it leaves the company to focus on selling the business opportunity over the actual product.

Poor Incentive Structure

These distributors are paid 100% commission, no base salary, and more often than not, the incentive structure rewards the distributor for selling the business opportunity much better than for selling the actual product. The company pays a commission to the distributor on both sale of products and recruitment of more distributors. Not only is the latter commission usually higher, but the distributor also earns a second level of commission when the person they recruited subsequently recruits other distributors, and then a third level of commissions can be earned when those new distributors recruit other distributors and so on and so forth. This is compounded by the fact that it is very difficult to sell the product (as discussed below).

Vemma, a multi-level marketing company that sells energy drinks, makes it quite obvious in their Compensation Plan that they offer much better rewards for the recruitment of independent distributors than for the sale their energy drinks. On the 5th page, they list out all of the commissions an individual can earn. The commissions for recruiting a distributor (classified as Builder Packs) range from $100-$200 per recruitment whereas the commission for the sale of packs of energy drinks range from $5 to $80 per sale, most being closer to the lower end of that spectrum. On top of that, it also displays how you are able to earn even higher commissions through recruitment, off your “downline” of recruits. It’s also interesting to note that, according to their Income Disclosure Policy, 92.07% of the participants in this program earn less than $6,000 a year, which is quite a different picture than the “Earnings Potential” they paint in their Compensation Plan.

Bill Ackman points out in his presentation (link in the conclusion) that Herbalife is no different, the company rewards its independent distributors much better for recruitment than for selling their nutritional supplements. He also points out the fact that the large majority of their distributors make only a few thousand dollars a year, resulting in an extremely high turnover rate.

Economically it makes much more sense for the independent distributor to focus their efforts on recruiting people to partake in the business opportunity (larger recurring commissions) over selling the actual product (lower one-time commission, difficult to sell).

Commodity Product and Illogical Pricing

Taking a look at the Wikipedia list of multi-level marketing companies, you can see most of the products these companies sell are non-differentiable commodity products. The products include:

-energy drinks
-nutritional supplements
-kitchen cutlery
-personal care products

When selling a commodity product, the competition is based on price. Without a sustainable cost advantage (which is far from easy to obtain in the first place), it is quite difficult to succeed selling a commodity consumer product. To add fuel to this fire, multi-level marketing products are often MORE expensive than their retail competitors, for many reasons including the fact that they need to compensate all the different levels of independent distributors.

Cutco Knives, a multi-level marketing company which sells a high-end kitchen cutlery, sells their set for over $1200. Compare this to a retail competitor such as Henckel, which sells high-end kitchen cutlery for less than half of Cutco Knives. Herbalife is no exception to this, as pointed out by Bill Ackman:

Herbalife Price Point

Source: factsaboutherbalife.com

How can a company expect to consistently sell an over-priced commodity product?

Ultra-Competitive Market

Multi-level marketing companies often compete in over-saturated markets and have a tiny market share. They face a plethora of competitors that utilize the traditional retail sales model, including established competitors that have been around for decades. If the product in question is a consumer staple, most consumers already have a go-to brand they rely on and are familiar with, so it would take a lot of effort to change their buying behavior to the multi-level marketing companies’ product.

It is hard to determine Herbalife’s exact market share by comparing their revenues with competitors because the company does not explicitly segregate revenues earned from recruitment and revenues earned from sales to consumers, despite the fact that they are two very distinct business lines in terms of operations, marketing and other efforts. Below is their revenue recognition policy (click to enlarge):

HLF Revenue Rec

Source: Company Filings

As you can see, they state that they earn revenues when product is transferred to the independent distributor, but notice how they don’t mention”customer” or “consumer” anywhere in their revenue recognition policy. Quite interesting given the fact that they are in the business (or supposedly) of selling consumer products. As a result, their market share of the nutritional supplement market (based on revenues) would be overstated because it includes revenues earned from recruitment.

The result of the ultra-competitive market is that multi-level marketing companies (or any company for that matter) have a harder time establishing their product and effectively growing within the market. Coupled with the fact that these products are commodity products and the lack of product development and marketing (discussed below) makes it extremely difficult to break into the market and successfully sell the product.

Lack of Product Development and Marketing

Product development at multi-level marketing companies  is usually quite low, (or as in Herbalife’s case, almost nothing). This results in a product that is simply not innovative and has no added value, confirming it’s commodity-like features as mentioned earlier.

Nu Skin Enterprises is a multi-level marketing company that sells cosmetic and personal care products.  In 2013 they spent around $14.9m in R&D (Source: Company Filings), compare this with a retail competitor, Estee Lauder, who is about 2.8 times larger than Nu Skin based on market capitalization but spent about 7 times more on R&D in 2013, $103.6m (Source: Company Filings).

The marketing is often surrounded around selling the business opportunity. The way they usually do this is to have successful, high-profile individuals endorse and support their company. They also display testimonials of current (or previous) distributors, flaunting their wealth and success they achieved through the business opportunity.

ACN, a multi-level marketing company that sells telecommunication products, pays Donald Trump to endorse their company. Most people have never even seen an ACN product in an advertisement or anything, but have seen Donald Trump endorsing the company. Please watch the video below:

Notice how they never really talk about the actual product? The entire video is around how successful Donald Trump is and the fact that he believes ACN is a great company. On top of that he really only praises the business opportunity, doesn’t say anything about the actual product. The endorsement is just to prove to distributors that if a wealthy billionaire endorses the company, it must be legitimate and the business opportunity is worth taking part in.

Again, as Bill Ackman mentions in his presentation (link in the conclusion), Herbalife is no exception to this. The products are not marketed at all but instead the company has David Beckham to sport their logo on his jersey in order to promote the legitimacy of the business.

How can companies expect to sell a commodity product that consumers have never even heard of or know nothing about?

Broken Sales Model

Retail maybe in a state of decline, but it is certainly not being replaced by direct-selling. Multi-level marketing companies take on anyone to become an independent distributor because there is no real cost of the company for doing so (and, as argued, thrive of recruitment of new distributors). As a result, the bulk of the independent distributors are inexperienced when it comes to selling and are quite new to the company, evidenced by the extremely high turnover/failure rate prevalent among these companies. It is simply unreasonable to expect someone who has no background in sales to sell on over-priced commodity product that no one has ever heard of in an ultra competitive market.

The companies do often include training however, the training is often carried out by independent distributors as well, with no real experience in sales. So you end up having a long chain of inexperienced independent distributors training other inexperienced independent distributors.

These consumer products are purchased as needed by the consumer. It is absurd to think that the direct-selling model, where the product is forced on to the consumer, is more effective than the traditional retail model (or online model) where the consumer seeks out the product as they see the need for it. The direct-selling method also simply cannot reach as many quality consumers as the traditional retail (or online model) effectively can.

The result?

A “competitive disadvantage”. Conditions that make it near impossible to have great success selling their product. Instead their business model evolves into…

Recruit distributors who will recruit more distributors, who will recruit more distributors, who will recruit more distributors….

Think of it this way, remove the business opportunity and what do we have left? A company that utilizes an inexperienced sales force using the ineffective direct-sales model to push grossly overpriced commodity products which are up against an abundance of competitors …how long would the company really survive?

Most multi-level marketing companies are in the business of selling business opportunities, with a small operation that sells a product on the side.

Below is a numerical illustration of the unsustainable nature of pyramid schemes and what would happen if you recruited 6 people, and then those people recruited 6 people and so on and so forth…

pyramid scheme Source: U.S. Securities and Exchange Commision

Can a multi-level marketing company ever be legitimate?

Yes, a company that utilizes a multi-level marketing strategy can be legitimate if they focus their entire business (marketing, operations, sales, R&D, etc.) around the actual product, just like their non-mlm competitors. They have to do their absolute best to ensure that they offer a product that is actually sought out by consumers and therefore can reasonable expect success selling the product. This concept is common sense to any traditional retail business.

If these companies were truly confident in their product, they would give the product to their independent distributors either on consignment or have the ability to return the product for a full refund if unsold (which neither actually happens in practice).

As the FTC states that an when a company earns 50% of more from recruiting, they are deemed an illegal pyramid scheme. Multi-level marketing companies are well aware of this rule, and monitor this quite closely. Bill Ackman goes into great detail in this presentation (link in conclusion) of how Herbalife utilize creative methods to make it appear that they derive a lot more revenue from end-consumers than from recruitment.

Conclusion

I am not claiming that all multi-level marketing companies are pyramid schemes, I am just pointing out the fact that the inherent design of most multi-level marketing companies often leads them to focus more on the recruiting “business opportunity” part of their business, rather than selling any product, forcing them to evolve into a pyramid scheme.

Bill Ackman displayed his deep research in his 3-hour presentation at the Sohn Conference and also compiled his research on Herbalife at factsaboutherbalife.com. I encourage you to check out his website where you can view the presentation and research, it is worth the watch/read. Despite the compelling research and evidence he has gathered, the stock price of Herbalife has surged over 200% in the past year.

As Benjamin Graham once said, in the short run the market is a voting machine and currently there are a few heavyweight voters such as Icahn, Soros and Loeb that have helped push the market capitalization of Herbalife north of $7 billion. It is hard to justify Herbalife as a sound investment and a good business, and their long positions in Herbalife (from a financial perspective anyway), are quite questionable. In the long run though, we shall see how much Herbalife really weighs.

Jathu Vasantharajah

This entry was posted in Business Theories, Case Studies. Bookmark the permalink.

7 Responses to The DNA of the MLM Business Model

  1. Hello Jathu,

    I personally have been following the HerbaLife momentum in and around the market. I have heard and did my research on their business models and actually seen some work, in the rare cases. In terms of key investors actually placing a long term bet I would tread carefully even with known hitters, since at the end of the day its your hard earned money.

    When it comes to drawing the fine line between MLM companies and having what Herbalife sells as a model it is quite intriguing. Going back to their revenue recognition policy, the end consumer product seems less important in comparison with the business opportunity.

    Also, it is nice to have you back on your blog. Looking forward to future posts.

    Regards,

    Swapnil

  2. Saquib Rashid says:

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