The Fortune Hi-Tech Lawsuit May Actually Help Herbalife

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The turmoil surrounding Herbalife (NYSE: HLF), a health products multi-level marketing company, seems to get increasingly interesting. First, there was the on-air verbal joust between celebrated investor Carl Icahn and hedge fund manager Bill Ackman. Then, it was reported that at the request of the Federal Trade Commission (FTC) and three states, a federal court halted an allegedly illegal pyramid scheme. The case alleges that multi-level marketing (M-L-M) company, Fortune Hi-Tech Marketing, defrauded more than 100,000 consumers since 2001.

The news of the FTC action seemed to pressure M-L-M stocks but surprisingly might help Herbalife's assertion that it is not a pyramid scheme.

Here's why:

The case against Fortune Hi-Tech seems to rest on two key points.

1. Fortune Hi-Tech falsely claimed consumers would earn significant income for selling its products and services.

As alleged, there is evidence that Fortune Hi-Tech promoted itself as a way for average people to achieve financial independence. Some representatives claimed they earned more than 10 times as much as their previous earnings in their second and subsequent years with the company. One person claimed that another representative earned more than $50,000 in his sixth month and millions of dollars in subsequent years. At its 2012 national convention, the company called its top 30 earners to the stage to present them with a mock-up of a $64 million check, which several of them shared as a photo on social networking websites.

2. Fortune Hi-Tech's business model emphasized recruiting new sales representatives over the sale of products and services.

The complaint indicates evidence that new entrants must pay at least $250 to be eligible for commissions and pay $250 annually to remain a commissioned rep. Further, they must purchase a "starter pack" to receive commissions. These packs typically cost between $130 and $400 and require the sales rep to agree to a "negative option continuity plan," whereby the rep is automatically billed monthly for products and services unless the rep affirmatively cancels the plan.

There is also evidence that Fortune Hi-Tech’s compensation program has both recruitment bonuses and commissions earned from product sales.

Once eligible, reps can earn a Customer Acquisition Bonus of at least $100 for each new individual they personally recruit to join, as well as for each individual recruited by other reps further down the line. This compares to a fractional amount earned from selling product. The complaint gives examples where the monthly amount available to a rep for the sale of a satellite TV package is $0.80 and the monthly amount for the sale of a cellular telephone contract is typically $0.50.

Given these facts, there doesn't seem to be any meaningful evidence that Herbalife resembles Fortune Hi-Tech Marketing at all. I haven't seen any consequential proof that Herbalife undertakes or endorses the notion that selling its product is a way to get rich quick nor have I seen any persuasive evidence that the company's business model emphasizes sales rep acquisition rather than product sales.

The latter is a key point. Unlike what some in the financial media espouse, multi-level marketing companies who emphasize the sale of product are legitimate firms. That discernment is important and the distinction is even stated in the latest FTC complaint, "Unlike a legitimate multi-level marketing business, FHTM's (Fortune Hi-Tech Marketing) business model emphasizes recruiting new Reps over the sale of products and services."

I think it might be reasonable to conclude that the significant differences with Fortune Hi-Tech, in addition to the differences from two other critical M-L-M pyramid scheme cases, may be helping Herbalife to increasingly prove itself legitimate and set itself apart from M-L-M frauds. (For info on the other two cases, see this article.)

But even as the controversy continues, the M-L-M and direct selling industry seems to be going about its business.

Nu Skin (NYSE: NUS), a M-L-M firm, now projects fourth-quarter revenue of approximately $588 million, representing growth of 19 percent over the prior year. The company also estimates full year revenue growth of more than 24% with sales coming in at $2.17 billion. Earnings growth is anticipated to be approximately 30 percent.

Herbalife said net sales for full-year and fourth quarter 2012 are anticipated to rise about 17.9% and 19.9%, compared to the prior year periods, respectively. Earnings for the fourth quarter are projected to be around $1.02 to $1.05 per share, compared to the prior year $0.86 per share.

Medifast (NYSE: MED), another M-L-M company, has just undertaken a nationwide advertising program. This bold action spots TV commercials that will run on networks including A&E, Lifetime and the Food Network. Print ads will also appear in publications including People, Better Homes & Gardens and Cooking Light.

The well-known direct selling firm, Tupperware Brands (NYSE: TUP), reported fourth quarter 2012 sales up 5% in dollars and up 6% in local currency. The company also said adjusted diluted earnings per share came in at $1.71 for the quarter and was 21 cents, or 14%, better than 2011 in U.S. dollars.

The stocks of M-L-M companies can be very volatile and Herbalife's situation makes it even more so. But while I believe that there is not sufficient evidence to indicate the company is a pyramid scheme, I would recommend anyone considering investing in the M-L-M space do their own investigation and come up with their own conclusion.

grahamsway (Bob Chandler) has a long position in Herbalife. The Motley Fool owns shares of Tupperware Brands and has the following options: Long Jan 2014 $50 Calls on Herbalife Ltd.. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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