Takeaway: Professor Anne T. Coughlan's weighs in on whether Herbalife is a scam. We also examine the differences between MLMs and pyramid schemes.
Today Hedgeye clients were treated to a private seminar with Professor Anne T. Coughlan, John L. & Helen Kellogg Professor at Northwestern University’s Kellogg School of Management. A recognized expert in distribution channels, direct marketing and sales force management, Professor Coughlan has received awards for excellence in teaching and is a sought-after consultant in the private sector, where she counts Herbalife among her clients. She appeared with Hedgeye in her capacity as an independent academic scholar and presented her own views on Multi Level Marketing.
Direct Selling & Multi Level Marketing
Professor Coughlan gave an overview of Direct Selling (DS), with a focus on Multi Level Marketing (MLM).
Direct Selling is well established in the retail marketplace. Compared with traditional “bricks and mortar” retail, “e-tail,” and franchising, DS offers certain advantages to both the company and the distributor. DS and MLM also have characteristics that make them look very different from traditional retail models. But, cautions Professor Coughlan – different does not necessarily mean illegitimate. Professor Coughlan described the key elements of DS, and of MLM, and contrasted the legitimate MLM structure with Pyramid Schemes.
All distribution channels address four basic issues:
- The combination of products and services – WHAT do consumers buy? HOW do they buy it? Consumers buy a product bundled with delivery services, and sometimes with post-delivery services – think of the expression “shopping experience.”
- The structure of the distribution channel – WHO is in the channel? HOW are functions allocated? WHO does the work at each step?
- Compensation – HOW are people compensated? WHAT are the incentives driving added-value activities in the channel?
- Governance – HOW is the program implemented and overseen? WHAT are the rules of conduct, rules for resolving conflicts and for protecting both customers and participants? HOW are channel participants’ investment protected, while ensuring end users access to a quality product?
The MLM Company
The MLM company develops the product and performs R&D and market research. The company administers the business: it sources product, performs quality control, and handles logistics to ensure inventory and delivery. In addition, the legitimate MLM company makes a significant investment in technology and administrative staff to effectively manage payment of compensation and incentive awards to its distributors.
The key characteristics of a legitimate MLM company include: actual product which is differentiated, usually by premium quality or scarcity. Legitimate MLM companies make their money from selling product, not from recruiting fees; they discourage distributors from taking on large inventories, and generally allow departing distributors to sell unused product back to the company.
Advantages of the MLM Model
Individuals are attracted to MLM selling for a number of reasons. Becoming an MLM distributor offers an aspiring businessperson an opportunity to try out their skills without incurring the cost and liability of setting up a business.
Distributors set their own goals and success is measured by individual satisfaction, not corporate guidelines. One reason revenues look very different among MLM distributors from the profile at a traditional retailer is that most distributors are satisfied if they can defray the cost of their own consumption of the product. Also, many people push their sales efforts seasonally – to pay for Christmas shopping, tuition or summer camp.
People become MLM distributors because they love the product, not to become financially successful. This is the biggest reason for low profitability in distribution downlines. Most distributors are satisfied with small profits and continued access to the product for their own use. Horror stories of housewives stuck with a garage full of shampoo and deodorant do not describe the operation of a legitimate MLM company.
Companies value star salespeople, and star MLM distributors are incentivized in a fully transparent fashion. Those few distributors who can successfully develop large downlines are the key to continued sales growth. While outsiders may think these business leaders are getting paid “off the backs” of their downline, they work very hard mentoring and training to ensure the success of their downline distributors, adding real value to the company. It is a rare combination to be a great salesperson AND a great recruiter AND a great trainer AND a great motivator AND a great mentor. Sales pros who can deliver on all these front are well rewarded.
A legitimate MLM company offers the same compensation structure to every distributor, and the compensation is clearly laid out, including incentive awards and the requirements for attaining them. Anyone can become a star. The fact that most people do not is attributable to human nature, not to a flaw in the business model. “The flaw,” laments Cassius to Brutus, “is not in our stars but in ourselves.”
So What is a Pyramid Scheme?
The primary characteristic of an illegitimate pyramid scheme is that people are paid to recruit others into the pyramid. Rather than derive revenues from the sale of product, pyramid schemes charge a registration fee, usually non-refundable. Many pyramid schemes do not even deliver an actual product, just an “opportunity.”
The first red flag is the compensation clause that says you get paid to recruit new distributors, even if they never sell anything.
Other red flags include a requirement to purchase large quantities of inventory, or requiring standing orders to be filled automatically, and which can not be returned if not sold. A pyramid scheme will not make a meaningful investment a product or an organizational structure.
How Do You Tell The Difference?
If distributors continue to use the product themselves, even if they are not making money off their own sales, Professor Coughlan says that is a strong indication a company is a legitimate MLM organization, and not a pyramid scheme. Remember that people get involved in MLM sales for a variety of reasons, and “value” is defined very differently in MLM than in structured sales organizations. If the company maintains R&D spending, it is a strong indicator that this is a legitimate MLM operation. The fact of individuals being more or less financially successful should not be seen as the determining factor, says Professor Coughlan.
Bottom Line: What About Herbalife?
We remind you that Professor Coughlan works as a paid consultant to Herbalife from time to time. Nonetheless, she was able to speak clearly about publicly available information, comparing it with financial information from similar public companies.
Professor Coughlan says, based on their public reporting, HLF’s compensation, production and distribution practices are comparable to industry norms, as are their interactions with distributors and end users. HLF does not charge high enrollment fees, and fees are refundable if distributors opt out within 90 days. HLF makes an ongoing investment in product design and buys back unsold inventory when distributors depart. The company discourages “inventory loading,” where distributors take on large quantities of inventory they may not be able to sell. HLF cites its own research showing “a lot” of end use by actual customers, i.e. buyers outside of the distribution downline.
Professor Coughlan says, based on publicly available information, HLF is comparable to other accepted MLM companies. The company’s compensation structure is “in the same ballpark” as other recognized companies, and the details of the compensation structure are well publicized across the distributor network.
Like other DS organizations, HLF’s distributors are the company’s own best advertisement, and it plows excess revenues back into compensation. Professor Coughlan says HLF’s total compensation is roughly equivalent as a percentage of revenues to the combined sales and advertising budget of major personal care companies with traditional sales forces made up of employees.
For a company that doesn’t advertise, HLF has gotten an awful lot of publicity lately – not all of it good. Professor Coughlan’s analysis provides a valuable framework for assessing the outlook for this company. The jury is still out, but it has just gotten an important new piece of evidence.
Watch our website for updates as Consumer Staples sector head Rob Campagnino continues to monitor developments at Herbalife.