Herbalife Shareholders Should Be Frightened by This FTC Release

Many of the reasons the FTC gave in announcing its decision to target now-defunct Fortune Hi-Tech Marketing apply equally to Herbalife.

May 16, 2014 at 1:44PM

Last January, the FTC halted Fortune Hi-Tech Marketing, froze its assets, and charged its executives with operating an illegal pyramid scheme. This week, the FTC reached a settlement with Fortune Hi-Tech, shuttering the company permanently, seizing assets, and banning its operators from the multilevel-marketing industry.

A similar fate could soon befall Herbalife (NYSE:HLF). With an FTC investigation ongoing, shareholders could, at virtually any moment, have their investment completely wiped out. Although such an outcome remains highly uncertain, the language used in the FTC's most recent news release should frighten Herbalife shareholders -- since much of what the FTC found disturbing about Fortune Hi-Tech Marketing applies equally to Herbalife.

Getting rich quick:

The FTC and the states charged the Fortune Hi-Tech Marketing (FHTM) defendants with deceiving consumers by claiming they would earn significant income through selling various products and services if they signed up as FHTM representatives.

Although Herbalife freely admits that few of its distributors actually earn any money selling Herbalife's products, its management team has a long history of making grandiose promises. Herbalife's founder, the late Mark Hughes, was perhaps the most aggressive when it came to selling the Herbalife dream:

Let me tell you how much money you're gonna be making... write this down. Put down your total income that you're making per month, right now. Write that down. Minimum, five times what you're making at this moment. Write that figure down. Stare at it. Get a feeling of it. Where could you be living? Some of you are going to be making 10 times ... what you're making right now.

Hughes is long gone, but Herbalife's top management, including board member John Tartol, have continued his legacy. In a video freely available online, Tartol tells distributors just how much money they could be making:

You could become a Millionaire Team member ... Wow! Can you imagine getting to tell people that you're part of the Millionaire Team! Such an honor! ... it's possible to earn a total of $5,500 or more [per month] ... Those who have reached the President's Team level ... could potentially be earning a total of $13,000 and up, every month!

Targeting Spanish-speaking immigrants:

In recent years, [Fortune Hi-Tech Marketing]  targeted Spanish-speaking and immigrant communities.

Ultimately, if Herbalife is found to be a pyramid scheme, the ethnicity of its victims shouldn't matter. Still, it's interesting that the FTC would choose to note this in its Fortune Hi-Tech Marketing release. The majority of Herbalife distributors in the U.S. are Hispanic (Herbalife's management reported in 2010 that almost two-thirds of its net sales in the U.S. were from Hispanics). The Hispanic Federation, a group that provides grants to Latino nonprofit agencies, urged the FTC to investigate Herbalife last year, noting that the promise of Herbalife riches could be of particular appeal to poor, Hispanic immigrants.

Start-up costs and renewal fees:

[Fortune Hi-Tech Marketing p]articipants were required to pay substantial start-up costs and monthly fees to retain their positions with the company. 

Fortune Hi-Tech Marketing required new participants to pay $249 up front. Herbalife's official start-up fee is less -- $59.50 or $92.25 -- but the company operates with the same basic structure. After purchasing am "Herbalife Member Pack," Herbalife distributors must earn a set number of "volume points" to retain their positions in the company.

These volume points are earned when the Herbalife distributor, or people the distributor has recruited to become new distributors (to a limited extent), purchase products from Herbalife. Each product (Herbalife's Formula 1 shake mix, for example) has a certain set volume point value that does not vary by region. In the U.S., one volume point roughly corresponds to $1 in terms of products purchased.

Herbalife requires that its members "requalify" on an annual basis in order to retain their positions within the company. In order to requalify, they must pay an annual fee and earn a set number of volume points every year. In an Herbalife instructional video, Tartol and Herbalife distributor Leslie Stanford explain:

To requalify as a qualified producer, all you have to do is accumulate at least 2,500 volume points within a 1- to 3-month period each year ... [To requalify as a] supervisor, achieve 4,000 volume points in one month ... or achieve 2,500 volume points in each of two consecutive months ... the third way you can requalify as supervisior is with a 12-month requalification method ... you have two options, you can accumulate 4,000 volume points within the 12-month requalification period ... all of those volume points must be unencumbered.

If this sounds confusing, it's because it is (note: the SEC warns would-be multilevel-marketing participants to beware complex commission structures). Suffice it to say, if you're a Herbalife distributor with any sort of downline, you will need to purchase potentially thousands of dollars of Herbalife product on an annual basis to retain your position within the company. 

Most lost money:

The overwhelming majority of people -- more than 98 percent -- [who bought into FHTM] lost more money than they ever made. At least 88 percent of consumers did not even recoup their enrollment fees.

Herbalife freely admits in its statement of average gross compensation that 88% of Herbalife distributors receive no income from the company whatsoever. Herbalife argues that these members receive "economic benefits" from the products they purchased through Herbalife at a discounted rate, but assuming they bought into the company with the intent to make money, then roughly the same percentage of Herbalife members as Fortune Hi-Tech Marketing distributors lost money.

Nearly all quit after one year:

... [a]t least 94 percent of [Fortune Hi-Tech Marketing] consumers did not renew their membership after their initial year.

In its 2005 annual filing, Herbalife admitted that roughly 60% of its supervisors exited the company in the prior year, and 90% of non-supervisors (lower-level distributors). This means approximately 80% of distributors left in a year. This information was not disclosed in subsequent filings, but, assuming Herbalife's retention has not dramatically increased, the company is seeing a turnover rate on par with Fortune Hi-Tech Marketing's.
Is the FTC foreshadowing an Herbalife shutdown?
Obviously, Herbalife is not identical to Fortune Hi-Tech Marketing, but the similarities are uncanny. Like Fortune Hi-Tech, Herbalife is operating a supposed multilevel-marketing business that promises riches, targets Hispanics, levies aggressive annual fees, enriches the few at the expense of the many, and sees a high annual turnover rate.
Will Herbalife, like Fortune Hi-Tech, also be shuttered by the FTC? Investors in Herbalife should be aware of the possibility.

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Sam Mattera is short shares of Herbalife via put options. The Motley Fool has the following options: long January 2016 $57 calls on Herbalife. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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