Thursday, July 25, 2013

Multi-level-marketing schemes and their distributors: notes on disappointed distributors at Herbalife and elsewhere...

When I was in my twenties I lived in outer North-Western Sydney for a year - mostly around Kurrajong. Multi-level marketing schemes were part of the environment - but two stood out: Amway and Avon.

Amway sold stupid and overpriced products which were direct substitutes for things that you could buy in a supermarket. I remember overpriced washing powder - and that is still there. (Check out this link where you can buy washing powder at 27 Australian Dollars per kilogram!) The Amway sales people (at least the ones I met) were a collection of drug dealers and no-hopers. I think at least one used Amway for (im)plausibly arguing that they money they had in their pockets was clean (when it came from dealing drugs). You could probably buy weed from many of the local Amway dealers.

I only met one Avon lady, a cheerful lesbian in her late 20s. She was (relative to the neighbourhood) quite prosperous and had an acre of land and horses. I briefly lived in a room attached to her stables. She was also (on her say-so but I have no reason to disbelieve her) the most successful Avon Lady in Australia.

Her shtick was simple: Western Sydney is a land of long commutes. Wives were stuck at home 11 hours a day (8 work, 3 commute) with the kids, lonely and getting depressed. The cheerful Avon lady would drop by and the women would play like 14 year old girls putting make-up on each other but without the cattiness... and the Avon lady would with all the (considerable and genuine) enthusiasm a lesbian could muster tell the housewife she was beautiful. And it was - like all good sales techniques - entirely plausible.

And she sold a lot of product. She sold (current dollars) well over quarter of a million dollars worth of product per year.

Now lets take Bill Ackman's rhetorical question about Herbalife and apply it to my Avon lady. Why would any customer buy protein shakes or cosmetics from a Herbalife or Avon sales person when similar products are available online much cheaper?

With the Avon lady the answer is obvious - which is that she was selling the service of making the customer feel good about themselves through lipstick, eye-liner and finger nail polish... she was not selling mere cosmetics. Multi-level-marketing provides a for-profit community support group and its name was Avon...

With Herbalife there is also clearly some of that. If I start a diet I am (statistically) not likely to stick to it. If I start a diet and exercise with a personal trainer (in this case preferably an attractive and cheerful individual who makes me feel good about myself) then I am probably more likely to stick to it (though still statistically likely to lapse).

Now the average Herbalife sales person is probably less inducement than the hot personal fitness instructor (except where the Herbalife sales person is the hot personal fitness instructor) but the effect is real. I described the Herbalife club in Queens as like Alcoholics Anonymous for fat Hispanic men: "my name is Jose and I am fat". And like AA Herbalife adds value through community support.

Indeed I suspect community support is actually more effective in weight loss than any individual supplement. Its the thing that keeps the dieter on the straight and narrow...

Failed and successful Herbalife distributors

McDonalds has a reasonable business. Being a McDonalds franchisee is also not a bad business - and the franchises trade hands for real (and sometimes considerable) money. McDonalds would however never franchise four restaurants (if you want to call them that) within one city block. If they did they would all be unprofitable.

McDonalds have a vested interest in their franchisees being profitable - profitable enough to keep the store clean, comply with labour and food safety laws and have toilets that don't stink. If the toilets stink and the food poisons customers McDonalds would fail.

Because McDonalds have a vested interest in the profitability of franchisees a franchisee of ordinary skill can make a living with a franchise - probably even a good living. That is why the franchises change hands for real money.

Multi-level marketers are different. MLMs simply do not have any control over the number of distributors. I might think that an area is saturated with distributors and that any more is foolish - but that is not going to stop you from recruiting - especially when you are paid as a percentage of distributor sales rather than distributor profits. MLMs will recruit until the profits of distributors go negative - sharply negative perhaps. If you find a profitable area as a Herbalife distributor (that is an area with lots of customers and limited competition) it will not remain profitable. Come back in five years - and there will be nine distributors none of which are making any money.

The MLM structure almost guarantees that most distributors have terrible businesses.

But it is worse than that. Your upstream distributor gets paid for recruiting you. And they get paid as a percentage of your sales - not as a percentage of your profit. They have an incentive to recruit you even if they know your business will be loss making. And they have an incentive to deceive you as to your prospects as a downstream distributor.

And if one of them (ethically) decides not to deceive you other upstream distributors will not be so honest. And so the network of an MLM - any MLM - is - simply by incentives - driven to the point where most distributors make losses and are recruited on false promises.

MLMs - all MLMs - are businesses that create and shatter the dreams of their distributors.

Herbalife does this too. There are many failed distributors - indeed the majority of people who try to make a living being Herbalife distributors fail. That is a feature of MLMs. Everyone who looks at MLMs closely brushes up against the failed dreams, the lies, the overly-slick and deeply unethical upstream distributors. This is true of Herbalife - and the rest of them - Amway, Avon, Tupperware, Nuskin, Pampered Chef and all the rest. [I am not accusing the MLMs of being disingenuous - just many of the distributors...]

High distributor failure rates does not make MLMs illegal. Indeed finding lots of failed distributors does not prove anything. It is to be expected - and there is no law that requires that everyone who opens a business - or even a majority of those that open a business make a profit. It does require however that a profit is possible because otherwise it would be misleading for the corporate to imply that the profit is possible.

And in most MLMs a profit is possible. Just ask the Avon lady above - who made enough money to keep land and horses in outer Sydney. But the Avon lady had a shtick. It was a good shtick and hard to duplicate. It meant she succeeded where others failed. And it was clearly an exception.

I have in looking at Herbalife found several profitable distributors. Indeed most the distributors around where I live are profitable albeit in a very small way. If you go down to Bronte Beach at ten o'clock on a Tuesday morning you will find fitness instructors keeping the local housewives in shape. The guys are bronzed and good looking. The women are the attractive thirty-something second wives of men rich enough to afford a house in Bronte. They are desperately conscious of their weight and appearance as they fear being traded in on a still younger model. And the fitness instructors not only sell fitness instruction and social reassurance [as in this bronzed guy tells them that they are attractive] but they sell weight loss products as well. Being a Herbalife distributor provides incremental revenue and little incremental cost. Its a good addition rather than being a good gig. And as noted above, a hot fitness instructor provides worthwhile assistance in weight control.

Distributor/customer failure rate

Losing weight if you are 40lbs too heavy is hard. Most people who try it fail. This is true of weight watchers, being nagged by your spouse, having a personal instructor or being on Herbalife. Its true of all diets.

One of the dumbest arguments I have heard (made insistently by StocksDD amongst others) is that the turnover in Herbalife customers/distributors is enormous and therefore Herbalife must be evil or at least burning the customers.

I would love to see the customer retention rate scatter amongst Herbalife distributors (my guess is the average is low and the spread is wide) and say Weight Watchers (probably with a similarly low average and wide scatter). The people I have met who are the most convincing Herbalife sales people have lost a lot of weight and kept it off for several years. These people are I expect the exception. Turnover and failure would be the norm.


PS. I am not so sure how you can be profitable selling washing powder at $27 per kilo. Herbalife products may be overpriced compared to generic competition - but the amount that they are overpriced is relatively small. Amway is ludicrous - just look at this link. And for the life of me I can't work out how "community" adds value to "washing powder". This is obvious for dieting, cosmetics, and cooking equipment.



tuvaorbust said...

I also wouldn't conceive a business selling expensive anti hair-loss treatments that don't work or anti ageing cream or breast enlargement cream etc but these businesses have been around a long time. I guess shorting a company based on the fact that its products are poor value is like betting that no more retail suckers will be born every minute and thats always been a losing proposition.

After all isn't champagne just cheap bubbly wine and pure sharks fins have no taste

John said...

Hi John,

That's one insightful analysis of the flaws of the MLM business model. With such built-in incentives to cause the distribution channels to self-destruct at some point, MLMs are not great business by Phil Fisher's definition. One will wonder why Buffett did not see that in Pampered Chef.

Anonymous said...

@John at 1:10
MLM distributon business is selling another dream. MLM sells two dreams at once. One is related to the product (diet, cosmetics), the other to the business model (be distributor, make $$$).
To be successfull in selling the second one, you need some exceptional success stories (and lack of awarness of survivorship bias). MLM are fat-tail stories. You get 9000 failed distributors, 999 so-so, and 1 outstanding success. You present your outstanding success & sell the sizzle.

Anonymous said...

The second wives in Bronte cost more than the houses....

Anonymous said...

Good points and interesting arguments.

One question: If that is the general case of the inevitability of MLM schemes, how much is Herbalife's success can be attributed to the product itself, to *new* distributors being misinformed, gullible or desperate for a get-rich-quick-scheme and to Herbalife's selective presentation and hiding of the failure rate?


Rene Porcile said...

Wouldn't you think that Ackman could have - at the very least, found 1000 HLF distributors to illustrate his point? For crying out loud, he shorted $1 billion of the stock! Given all the assumptions that HLF has caused harm to people, finding 1000 failed distributors to show the world should be easy. Show us how much each one of them lost. It wasn't done because it can't be done.
Shorts explain why, when surveyed, 87% of FORMER
Distributors would recommend Herbalife products to friends and family, and 63% of former Distributors would recommend becoming an Herbalife Distributor.
Go to slide 47 here to see my reference...
As far as the laws being broken - the FTC has NOT been asleep. In fact, they recently closed down a MLM company without any press pressure or Ackman, etc...

Rene Porcile said...

There are lots of choices people have to getting healthier and HLF is major constructive player in this field. With results - not just talk!

Why? The products work, the training system works, the pay plan works...
Plenty of people needing help,remember - America is in a "Health care Crises" Who's going to help? The fast food industry? The pharmaceutical industry? Big-Ag industrial farming?

Many will help, even fast food chains have salads, right? GNC, Vitamin shoppe, natural food stores, etc will help, sure.
HLF, Usana, Natures Sunshine, etc will help, sure.

HLF is poised to win big because of their products and their track record of success is second to none.

Anonymous said...

Interestingly I've never known a lesbian who fell for the Amway shtick (and I know a lot of lesbians).

Straight friends of my various family members, on the other hand....

Lauren Taylor said...

It seems Bill Ackmann had the argument right in that these schemes leave much to be decided. However, the demand for the existence of these business models from people who want to complement the income is too strong for regulators to ignore. They prohibit the whole industry. It is not realistic. Thus, the only alternative is to tolerate it and punish blatant abuses.

Anonymous said...

Amway is not competing with supermarkets. They are competing with the Jehovah's Witnesses and other cults. The songs the Amway agents used to sing at a local motivation meeting were disturbing for a for-profit company

panda said...

Even at wholesale, the products are priced in order to compensate for the rebates of 9-12levels of distributors upstream + points value percentage for the added rebates and points pairing if binary + the company mark-up.

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