Sunday, October 6, 2013

Russian SEC Member Calls Herbalife a Pyramid Scheme

Herbalife (Photo credit: netodarkis)
Andrei Volgin, who claims to be a member of the Russian Securities Market Commission (their equivalent of the American SEC), just published an essay on SeekingAlpha, where he declared FLAT OUT that HERBALIFE IS A PYRAMID SCHEME. Not only he's joining Ackman in the short, he thinks it's perfectly ETHICAL thing to do.

You may or may not agree, but it's worth reading his points, and he brought up something I had thus far neglect to mention: the churn rate in MLM.

The "churn rate" of a MLM is the amount of distributors that does NOT choose to continue participating in the MLM. It is sometimes known as the "attrition rate" or "distributor turnover". (see wikipedia)  However, how does it affect whether the business is a pyramid scheme or not? That again, goes back to the matter of "self-consumption".

According to Herbalife's SEC 10-K filing of 2004:
For the latest twelve month re-qualification period ending January 2005, approximately 60 percent of our supervisors did not re-qualify and more than 90% of our distributors that are not supervisors turned over.
This was left in the footnote was one of the tables in the filing, NOT in the main body of text. (One wonders if Herbalife was hoping people will ignore it? But let's put that observation aside...) What does that MEAN? 

It means 60% of the people who were earning multi-level commissions ("supervisor") failed to KEEP earning such, by meeting "sales goals" (of 2500 points for 2 consecutive months, or 4000 points for a single month) just ONCE out of that 12 month period ending January 2005. In other words, 60% of people qualified for "supervisor" once in 2003 (bought at least $4000 of stuff), failed to requalify in 2004 (i.e. buy that much again)

But here's the shocker: "more than 90% of our distributors that are not supervisors turned over." As it's the SAME SENTENCE, there's only one interpretation: over 90% of "distributors" (from 2003, did not qualify as supervisor with the big purchases) bought NO Herbalife product in 2004 (i.e. turned over)

The conclusion is simple: Herbalife has very few repeat customers, not enough to support the lowest rank of distributors. 

Which leads to another conclusion: only the people on the top are getting rich because they are attracting a new bunch of distributors every year who were told to buy a starter kit and TRY to sell it to over people (and failing, so they quit, and replaced by a new batch next year). 

Such is a sign of pyramid scheme: if you stop recruiting, you die. 

In a pure pyramid scheme, if you stop recruiting people, then no money will feed the system, and thus the whole thing grinds to a halt. 

In a direct sales business, if you stop recruiting sales people, money will STILL flow as existing sales people will keep making sales and make commissions. 

So what happens when you stop recruiting people in Herbalife? This is where the churn rate comes in. If HALF of the distributors quit, and VAST MAJORITY of people below them also quit during year, and were not replaced, what will happened to the sales figures? It'll halve each year (Hypothetically) or worse.

How can this be a viable product if most people who try it quit within a year? How can a business be viable with product like this? By recruiting faster than people leave (and everybody buy enough for oneself).

According to Herbalife's 2012 income disclosure statement, 71% of all distributors makes NO multi-level commission, and another 13% makes $104 average PER YEAR with single-level commission. 

Out of these 84% of all distributors (over 400K people), apparently VAST MAJORITY ("over 90%") will not keep buying Herbalife... if we are to assume the statistics from 2004 continue to hold.  Vast majority will quit, to be replaced by yet other people eager to buy Herbalife, not to sell them. 

The company (at the top) and the top distributors, who have amassed so many downlines that their mid-level will automatically recruit more to replace the losses, will continue to rake in the commissions. The mid-level barely stay afloat, more of their efforts are in replacing the losses from the churn. And the low levels, who buy starter kits and some beginning inventory, fed money into the system to be filtered upward. A lucky few will accumulate enough downlines to move to mid-level but the rest simply end up as churned chum and spat out, bloody and bruised (and much poorer). 

That is not a business. That is a pyramid scheme. albeit a pyramid scheme that can manage to survive for a while, instead of IMMEDIATE death like a pure pyramid scheme. 

Which is why I previously called Herbalife a POTENTIAL product-based pyramid scheme. It has NO statistics to prove itself is NOT such a thing. And thus far, it is using only circumstantial (and irrelevant) statistics to attempt to exonerate itself, with stuff like "surveys".  Herbalife's survey done in 2013 that "most people who know Herbalife products will buy them again" was done in attempt to refute Ackman's charges.

Survey is about PERCEPTIONS, which are subject to propaganda and cognitive biases. Actual statistics of distributors selling or turned over are real numbers. As the old adage goes: "actions speak louder than words". Or in this case, "if they are happy, they would not not have left".

There is another angle to consider: Why won't Herbalife publish REAL STATISTICS about how many people really continue to be distributors and who left the company, but instead, rely on surveys?

One wonders if they know the answer, and they don't want it to become public knowledge.

Go read the guy's essay. You don't have to agree, but you'll learn quite a bit.

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