Multi-Level Marketing Is Bad Business

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I’m not sure if Pershing Square’s Bill Ackman will win in his quest to bring down multi-level marketing giant Herbalife (NYSE: HLF). Given the recent rally, activist investor Carl Icahn might be successful in forcing the “mother of all short squeezes.” Neither result would surprise me.

But, regardless of what ultimately happens to shares of Herbalife, the MLM business is itself fundamentally flawed. Is there another business model (not just a business, but the entire model) that has received as much scrutiny as MLM?

Given the fine line MLM businesses must walk to stay on the right side of the law, I'm not sure why anyone would invest in a company like Herbalife, or for that matter, other MLMs such as USANA (NYSE: USNA) and Nu Skin (NYSE: NUS).

Criticisms of MLM

MLM critics are easy to find. These are not investors, but common people, running literally dozens of sites around the web dedicated to exposing the questionable practices of MLM companies. Their motivations appear to stem from a genuine concern for the apparent victims of the MLM system.

PyramidSchemeAlert defines its purpose as educating consumers to “[reduce] the number of illegal and de facto pyramid schemes and victims.” An article on the site published January 2012 (long before Ackman got involved) noted that a Belgian court had ruled that Herbalife was an illegal pyramid scheme:

After years of delay in the Belgian courts, a ruling was finally gained: It concludes that Herbalife is exactly what the consumer group claimed it is, an illegal pyramid scheme based on “endless chain” recruiting. Such a plan dooms the vast majority to losses, by its design and deception...The court revealed that Herbalife plays a shell game, depending on whether it is reporting to the SEC and shareholders, arguing to the court, or recruiting consumers, in which sometimes the salespeople are described as “direct sellers” or “distributors” and at other times as “customers.”

PyramidSchemeAlert has also been critical of Nu Skin, and more broadly, the entire concept of MLM.

The Vegas performers and social commentators Penn & Teller have also publicly attacked MLM. In an episode of their now-defunct Showtime series, the comedians laid out the case against the business model (the entirety of the episode has been uploaded to Youtube, and is worth watching if for nothing other than its entertainment value; be warned, it does contain some graphic language).

In their 30-minute takedown of MLM (in which they euphemistically refer all MLMs as pyramid schemes), Penn & Teller don't focus on any publicly traded MLMs in particular, although they do mention Herbalife by name.

Ironically, websites and Youtube videos criticizing MLM have become so commonplace that some working within the MLM system have disguised their promotional materials to appear -- at first glance -- like a whistleblower’s.

For example, a Youtube user by the name “JusticesMLMreviews” uploaded a promotional video for USANA entitled “USANA Scam? Why Didn't Other USANA Reviewers Tell You This?” In it, he admits:

Now, if you're watching this video... you're out there doing some research [on USANA]. Going around the web, finding out what people are saying, finding out if USANA is a legitimate company, or if they're a scam...Regardless of some of the negative things you may see online, USANA is definitely not a scam...Where does this stuff come from? Where does the negative stuff come from about a company like USANA? You're gonna see negative stuff like this about a lot of network marketing companies.

The central question of MLM

Ultimately, the legality of an MLM comes down to one question: are participants involved legitimately selling goods? Or is the primary focus simply to recruit new members into the scheme?

An interesting point about Herbalife in particular is the company’s practice of establishing “Nutrition Clubs.” These are locations where Herbalife distributors can move their product, and apparently, recruit new members into the Herbalife distribution scheme.

Many of these Herbalife Nutrition Clubs have websites and Facebook pages. Consulting a few of them suggests what the Herbalife distributors are really after.

An apparent Michigan-based Herbalife distributor runs a website called “HerbalHub." The copy on the landing page is devoted partly to weight loss, but largely to learning about “[earning] income at home.”

Investing in MLM

Since the end of December, shares of Herbalife are up an impressive 74%. Most of that rally has been prompted by the involvement of Carl Icahn, who has bought over 16% of the company’s shares since January.

Along the way there’s been some negative news, like last week’s letter from the Hispanic Federation, urging the FTC to investigate Herbalife. Still, shares have continued to power higher.

As similar multi-level marketing companies, USANA and Nu Skin have traded largely in tandem with Herbalife, boasting their own 50%+ rallies over the same period.

Shares of all three companies should continue to move higher if Icahn is successful in squashing Ackman’s criticism. Indeed, given that the FTC has allowed Herbalife and other multi-level marketing firms to exist for decades, the safer bet might be to side with Icahn.

At the same time, it’s quite clear that MLM is, at best, a questionable business model, one that has long faced criticism and even accusations of fraud.

Short seller Jim Chanos, famed for shorting Enron ahead of its collapse, admitted on CNBC that Ackman’s analysis was “correct” because Herbalife’s business was “ultimately flawed down the road.”

Playing a short squeeze might prove profitable, but I fail to see why anyone would plan to invest in these companies over the long term. Perhaps that’s why Dan Loeb, after buying stock at the beginning of the year, recently sold his entire stake.

Other long-term investors might consider doing the same.

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Joe Kurtz has no position in any stocks mentioned. The Motley Fool 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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