Herbalife Doesn't Deserve to Die
As almost everyone knows by now, hedge fund manager Bill Ackman really doesn’t like the way Herbalife does business. This is because the company’s business model has a hint of pyramid scheme to it. As a distributor of Herbalife’s shake mixes, vitamin supplements, snacks and the like, you make money by signing up other distributors. Those who get in early can make big profits, while most distributors don’t make money at all.
There are lots of other things in our world with a hint of pyramid scheme to them, some obvious scams, some not. Ponzi schemes like the one perpetrated by Bernard Madoff rely on cash from new investors to pay off the early ones. Then again, Social Security sort of works that way too. And really, anybody who invests in stocks and bonds -- including Ackman -- is to some extent relying on future investors to bail them out.
What makes Social Security and the business of investing in something other than sure-to-collapse scams is underlying economic growth. As economist Paul Samuelson famously wrote in 1967, “A growing nation is the greatest Ponzi game ever contrived.” Transparency helps, too. Slowing growth and rising life expectancy in the U.S. mean Social Security won’t be as a great a game for current workers as it has been for their elders. But this is disclosed in great detail every year in the Social Security trustees’ report.
When it comes to so-called multilevel marketing companies such as Herbalife -- other big names in the field include Avon, Amway, Nu Skin, Primerica, Pampered Chef and Tupperware -- what distinguishes legitimate businesses from illegal pyramid schemes is similarly a combination of underlying demand and transparency. At least, that seems to be what has distinguished them since 1979, when the Federal Trade Commission determined that Amway was not an illegal pyramid scheme. This dividing line isn’t explicitly defined. When New York Times columnist Joe Nocera tried to get a definition out of the FTC earlier this year, the response was, “we won’t be able to offer you any on (or off) record assistance.” A former FTC economist told Bloomberg's Matt Stroud in February that the lack of a clear rule makes it hard for the agency to crack down quickly on even the most obvious scams.
Now back to Herbalife. Its flagship Formula 1 meal replacement shake powder has sales that are “more than double those of its three leading competitors -- Ensure, Kellogg’s and SlimFast -- combined,” Fortune’s Roger Parloff writes in an epic and hugely educational new examination of Ackman’s battles with the company. Parloff cites extensive Herbalife-funded research showing that the vast majority of its products are being consumed rather than moldering in distributors’ garages, then adds:
Investors were understandably skeptical of any company-ordered surveys. So several funds did their own. One longtime major investor told me he commissioned a blinded, high-datapoint, randomized survey asking a wide variety of questions. The results basically lined up with Herbalife’s, he said. “Say what you will,” he comments, “you may think the stock’s overpriced, you don’t think it’s a good business opportunity, or whatever. It’s impossible to argue there isn’t a product.”
As for how it recruits and communicates with distributors, Parloff reports, Herbalife seems to have done some pretty dodgy things in its early days, but has cleaned up its act a lot since former Disney executive Michael Johnson became CEO in 2003 -- and cleaned it up even more since Ackman began targeting the company in December 2012.
In recent years a big growth area for Herbalife has been “nutrition clubs,” in which distributors invite customers to gatherings with an admission price of $5 or so where Herbalife products are consumed and weight-loss progress is discussed. The concept got its start in Mexico and is concentrated in low-income communities in the U.S. This sounds a bit like some of the business ideas expounded by the late management scholar C.K. Prahalad in “The Fortune at the Bottom of the Pyramid” -- by doling out products in smaller portions, you not only make them available to people who couldn’t otherwise afford them, but provide new small-scale entrepreneurial opportunities for the sellers.
It can also be a way for unsophisticated would-be entrepreneurs to get in over their heads, which is what caught the attention of financial researcher Christine Richard, the former Bloomberg News reporter who put Ackman onto Herbalife. She and Ackman aren’t alone in this concern -- consumer groups and Hispanic organizations have also been critical of Herbalife, and the FTC started investigating the company’s business practices last year. Investors have at times also seemed to lose faith in the company, although the stock price has been on the rise this year.
Maybe all this scrutiny will bring about a shift in government attitudes toward multilevel marketers in general. Herbalife and its MLM peers expend a lot of money and effort lobbying Congress and the FTC in defense of their business methods; surely it's healthy to have somebody with lots of resources pushing in the opposite direction. Still, it’s hard to imagine Ackman's campaign bringing on a collapse of Herbalife, his avowed aim. An Al Jazeera America investigation of Herbalife nutrition clubs in the New York City borough of Queens found examples of successes as well as failures. For all the potential abuses inherent in its business model, Herbalife makes products that some people willingly buy.
Should they want to? I don’t think I’m the one to say, and neither is Ackman. There is some modest evidence that meal-replacement shakes such as Herbalife’s can actually help people lose weight; some of the other products the company peddles are of more dubious value. I doubt any of them is as bad for you as a Krispy Kreme glazed doughnut or a Big Gulp of Coca-Cola, though.
I happen to have an obsession with sugary cereals that masquerade as healthy fare. In my view, Honey Nut Cheerios are a travesty, relying as they do on the brand umbrella of their wholesome, low-sugar parent (regular Cheerios) to sneak what is basically candy onto Americans’ breakfast tables. If I had Bill Ackman’s resources, I might expend some of them trying to warn consumers away from such junk. I’m pretty sure I would not, however, start a short-selling campaign aimed at driving General Mills into bankruptcy. Just because you don’t like a business doesn’t mean it is destined to die.
The terms Ponzi scheme and a pyramid scheme are often used interchangeably, although the useful Wikipedia page on the former proposes that Ponzis are usually run by a single operator who claims to be following some esoteric investment strategy, while pyramids rely on well-compensated recruits to spread the word and usually acknowledge that the money comes from adding yet more participants.
Prahalad, just to be clear, was referring not to pyramid schemes but to an income pyramid in which the largest numbers of consumers were at the bottom.
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