Herbalife: Not A Pyramid Scheme

Herbalife Limited is claiming victory following the announcement of results of a two-year investigation into its business practice and methods.

The Federal Trade Commission (FTC) has concluded its report into the company’s business model, determining that its method of sales does not constitute a pyramid scheme, even if many of its features resemble one.

This is welcomed news for billionaire investor Carl Icahn, who has released a statement which says that the FTC decision “vindicates” his long-held convictions that the company’s business practices are legitimate.

He has also been given the right to increase his shareholdings from 18% of Herbalife’s common shares, to just under 35%.

Icahn reiterated his support for the company’s CEO Michael Johnson, as well as the management team, who he says have led the company with skill during the three-year battle over claims by critics that the company operates in a similar fashion to a pyramid or “Ponzi” scheme.

So what’s the story then?

What is Herbalife and why was it investigated in the first place?

Herbalife Ltd was incorporated in 1980 and sells a selection of health products including protein shakes, snacks, and weight loss products.

It does not sell through shop fronts; rather it uses sales representatives to promote the products directly to the consumer.

Distributors make a commission on sales.

As a business model, it is not unlike other companies like Amway, Tupperware, and Avon which sells directly to the market.

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So why is it different from those other companies?

The allegations against Herbalife were brought about by its use of recruitment, rather than sales, to earn participants their commission.

There are a number of ways in which a Herbalife salesperson can earn money, but the primary way was by collecting a percentage of the commission money generated by those recruited into the scheme by the initiating sales person.

Joining Herbalife as a seller requires either sponsorship from an existing member, or being referred to one.

The sponsor or existing member then receives a percentage of the commission generated by the new member.

In other words, profits are not made from the sale of the product itself, but on successfully encouraging others to sell the product on behalf of.

What started the investigation at Herbalife?

Pyramid schemes are illegal business models, because they are inherently unsustainable, and because only a few people (at the top of the pyramid in the above chart) actually benefit.

Critics, foremost among them being hedge fund manager Bill Ackman of Pershing Square Capital Management, have claimed that the company:

• misrepresents earnings potential
• promotes an unrealistic level of remuneration for its sales people
• is unsustainable
• fails to mention the high start-up costs
• depends on selling the sale, rather than the actual product.

Ackman has gone as far as “short” betting approximately $1 billion against the company in his bid to have its processes declared illegal.

Why did the FTC determine in Herbalife’s favor?

The FTC reached a settlement with the company, by which Herbalife agreed to pay $200 million for claims of misrepresentation.

It also agreed to modify its business practices by making sure that sales figures are largely made up of sales of the product to consumers outside of Herbalife – the final users of the products – rather than sales to people inside the Herbalife circle.

It has also agreed to be subject to monitoring for seven years to ensure its compliance with this.

Where to now?

Is this a win or a loss for Herbalife?

By avoiding the damning term “pyramid scheme” in reference to its business practices, Herbalife is able to stay in business.

Immediately following the announcement that the FTC ruled in its favor, stock prices increased by 15%.

The graphs below show how the share price looked in the lead up to the announcement and immediately following:

Although Icahn claims to be on good terms with Ackman, he does concede that their viewpoints continue to differ.

He also sees the end of the battle as the start of new opportunities for the company.

However, the company has been forced to settle claims of misrepresentation and is having to revisit its business practices.

Even the company’s CEO, Johnson, refers to Herbalife’s recruitment policy as being fundamental to its success.

The FTC’s recommendations include changes to business practices which include the company ensuring that the way it records sales is accurate.

With extra scrutiny now squarely fixed on how recruitment affects sales, it will be interesting to see what the profits look like in a couple of years.