Herbalife's Sneaky Business Activities in China Raised Suspicion: Disguised Form of Recruitment Fees Gives away Its Pyramid

Scheme August 12, 2013 15:08 Source: First Financial Daily

http://finance.people.com.cn/n/2013/0812/c1004-22533735.html

Herbalife (NYSE: HLF), a global nutrition product magnate, has continued to be drawn into the whirlpool of the bull-bear battle since last May. Hedge fund manager William Ackman accused Herbalife of practicing a pyramid scheme and thought that Herbalife makes money by recruiting members rather than selling products. It is worth noting that, since August this year, financial guru Soros, as reported by overseas media, has taken a sizeable long position in the stock of Herbalife. He was another billionaire investor who joined the alliance of Herbalife's backers since the Herbalife bull-bear battle. Herbalife share soared over 10% on the day when this news was released. As the bull-bear battle unfolds at full scale, apart from its performance in the capital market, Herbalife's management and control over its distribution and the effects of its products have caught the attention of the industry. Recently, First Financial Daily discovered through private investigation that, while Herbalife is fast growing in the China market, its sales model is suspicious in five respects: collection of "recruitment fees" in disguised form, suspected exaggeration of product effects, possible windfall profit derived from products, fast growing clubs absent of strict supervision and control, and product purchase overly dependent on sales representatives or potential sales representatives A series of issues have deviated the direct selling model of this company, and have contradicted with certain provisions in the "Regulations on the Prohibition of Pyramid Selling" promulgated and implemented by the State Council in 2005. As a result, suspicion has been brought up that Herbalife's sales model is a pyramid scheme. "Recruitment Fees" in Disguised Form "Xiao Zhong, you'd better order products worthy of 1000PV these two days, so that we can get you promoted to senior business representative and you can then develop your own client base and get commissions." Business representative of Herbalife, Li Ming (pseudonym), who had introduced one of our reporters to become a premier customer of Herbalife, kept urging our reporter to purchase Herbalife products, although our report kept telling Li Ming that he has no intention to do so. Li Ming explained that Herbalife evaluates performance on the basis of the PV value. 1PV equals to RMB12. A monthly sales turnover of RMB1200 to 48000 (i.e.100PV to 4000PV) would generate a 15% to 30% sales commission. Li told our reporter that he has to invest by purchasing the products before making money and it would be pretty easy to sell the products afterwards. However, if our reporter fails to sell
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the products, he would not be able to become a business representative and therefore would not be entitled to commissions. Herbalife's trump card is its direct sales representatives all over the country. However, it is not easy to become one of the direct sales representatives. One of the key conditions is that you need to purchase Herbalife products up to a certain quantity; and such a disguised form of "recruitment fees" may constitute a violation of the relevant provisions of the State. As requested by Li Ming, our reporter has to buy 1000PV (i.e. RMB12000) worth of products before he can become a direct sale representative of Herbalife. Our reporter found Li Ming through private investigation and told Li Ming that he wanted to become a direct sales representative of Herbalife. However, after Li Ming enrolled our reporter as a premier customer, he kept putting off allowing our reporter to become a business representative (i.e. Herbalife's direct sales representative who is entitled to commissions through sales of products). He told our reporter that he should take a certain quantity of Herbalife products before he could become a sales representative as that would make our reporter have a better idea of the products. When our reporter kept making excuses for not buying the products, Li Ming told him flatly, "it is impossible for you to become a business representative without buying the products, and such a quantity of products are easy to sell." When our reporter joined another franchised club under Herbalife, a sales representative also insisted that our reporter must purchase a certain quantity of products before he could become a sales representative. In accordance with Article 7 of Chapter 2 of the Regulations on the Prohibition of Pyramid Selling effective as of November 1, 2005, "if an organizer or operator seeks for unlawful interests by recruiting people to participate in pyramid selling and asking the recruited person to pay fees explicitly or in any disguised form (such as purchasing commodities) for obtaining the qualification for participating in pyramid selling or recruiting others to participate in pyramid selling, it shall constitute an act of pyramid selling". The acts of the direct sales representatives of Herbalife who asked people to purchase products as a condition to becoming a direct sales representative is very close to pyramid selling. In order to lure our reporter to become a business representative promptly, Li Ming kept telling our reporter the advantages of becoming a business representative. Our reporter asked a direct sales representative how much he earns a month. He told our reporter, "I have been doing this for only half a year and I earn about RMB20,000 a month now ." While our report was feeling surprised about the high income they earn, Li Ming waved his hand and added, "this is nothing." Direct Sales Representatives Make "Prescriptions" at Will Although the direct sales representatives kept trying to persuade our reporter to purchase products so as to become a "member", the way they promoted the health 2
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products was not professionally convincing. For various symptoms pointed out by our reporter, these direct sales representatives gave quite similar "prescritpions". A kind of protein drink mix product almost became the "panacea" that could cure all health problems. "Does Herbalife have any product that can cure insomnia?" Our reporter went to a Herbalife nutrition club located in the Yangpu District and pretended to be a customer who has a health problem to solve. A sales representative in the store immediately recommended the Herbalife protein drink mix to our reporter. "Our protein drink mix contains not only rich protein, but also dozens of types of vitamins. After you have improved your body, quality of your sleep will naturally improve." Our reporter challenged the sales representative immediately that this product's main function as advertised before was for weight loss. The sales representative continued to explain, "this product helps to lose weight if you use it to replace two meals a day. If you don't want to lose weight, you can use it to replace one meal a day and it will also improve your health." When our reporter added that he suffered the syndrome of deficiency-cold of the spleen and stomach, the sales representative recommended to him the same product, i.e. the protein drink mix. "Your problem lies in the lack of body conditioning and deficiency in detoxification. Using our product will help improve your body." Our reporter noticed that the sales representative used his mobile phone to search on the "Baidu Knows" web page when he explained to our reporter. Furthermore, the sales representative showed our reporter a product brochure, which introduces recommended combinations of Herbalife products for improving various health problems. Our reporter noticed that the health problems listed in the brochure include obesity, insomnia, gynecological inflammation, chronic cholecystitis, chronic pancreatitis, hyperthyroidism, colitis, rhinitis, hypertension, hyperlipidemia, coronary heart disease, liver cirrhosis, and dozens of other diseases, and the improvement plans for almost each of the health problems include the protein drink mix mentioned above. The sales representative explained, "the protein drink mix is a basic product of Herbalife as it is rich in proteins and various vitamins, and therefore it is a basic product for improving various types of health problems." He also mentioned that the protein drink mix has detoxification and anti- stress functions. However, does the protein drink mix, as a basic product of Herbalife, indeed have the magical effect of "curing all kinds of diseases" as suggested by the sales representative? Our reporter got in touch with several consumers who used to use Herbalife products. Generally, these consumers felt that their health improved to certain extent, but it was not that obvious. "All health products will certainly improve your health to certain extent. But are they as amazing as the advertisement says? I have been using Herbalife products for more than a year but do not have obvious feelings." Windfall Profit Hidden in Weight Loss Products 3
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What is the underlying secret behind Herbalife's weight loss products which their direct sales representatives claim to be the best-selling products globally? After consulting with a direct sales representative of Herbalife and certain analysis, our reporter discovered that the main ingredient of Herbalife's star weight loss products is a mix of protein, vitamins and minerals. The principle of weight loss is to cut down your food intake and at the same time supplement certain nutritive elements. Such method is similar to taking skimmed milk and fruits for one to two meals out of three meals every day. However, such a simple weight loss principle costs the consumers tens of thousands of RMB each year, which is a price much higher than similar products on the market. Further, despite the high prices of the Herbalife products, the proportion of Herbalife's R&D and marketing costs to its revenues is not higher than those of the manufacturers making similar products. Our reporter attended an internal weight loss products presentation organized by Herbalife. More than a hundred participants attended the meeting, and effects of Herbalife products were introduced at the meeting. Herbalife's signature weight loss product is a protein drink mix which can be made to milkshake and be used as meal replacement (for normal meals). Our reporter interviewed some consumers who had tried such product. They generally felt hungry at the beginning when they took the product. In fact, such a dietary method is not quite different from reducing the quantity of food intake. Herbalife's product introduction claimed that the major ingredients of such product are soy protein, vitamins and minerals, and the product is low in cholesterol, fat and calorie. Wang Dahong, the Secretary General of the Market Task Committee under China Health Care Association, pointed out that, the main principle of Herbalife's protein drink mix is to, through meal replacement, reduce fat intake of the body and therefore realize weight loss. Wang Dahong also told our reporter that, it is true that some sales representatives on the health product market in China are not equipped with sufficient knowledge in the relevant field. "Consumers should pay attention to the product ingredients and effects printed on the external packing of the health product when they select health products, and don't easily believe the effects of a product which are not indicated on the packing but claimed by the salesman. It's better if consumers can consult with nutritionists when necessary." To that end, experts remind the consumers to choose health products according to their health condition. According to the "Reference Intake Amount of Meal Nutrients for Chinese Residents", there is a reference range of the quantity of vitamins and minerals that should be taken by an adult every day. If the intake exceeds the regular quantity, it would also affect the health. Also, certain types of health products may not be good for special populations. For example, protein nutrition products are not good for people who are allergic to protein and have renal dysfunction. 4
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Surprisingly, Li Ming introduced that, on average, a dieter would spend two to three thousand RMB every month for weight loss products. A consumer who had been trying the Herbalife weight loss product for a week told our reporter that, although some consumers appeared in the events organized by Herbalife claimed based on their own experience that the product worked after one week, it didn't seem to work on her after she had tried such product for one week. According to the plan, this consumer needs to spend around RMB2,000 each month, and according to the sales representative, she needs to persist all the year round. At present, the series of weight management products sold by Herbalife make up 90% of Herbalife's sales turnover. In order to understand whether the pricing of Herbalife products is reasonable, our reporter selected some Herbalife products and compared them with similar products on the market. The prices of Herbalife products are in general higher than those of the similar products on the market, but the proportion of R&D costs to the revenues is lower or close to that of the similar products. Our reporter compared Herbalife's Performance Protein Powder, Vitamin B Complex, Vitamin C Lozenges and cleansing milk products with similar products on the market and discovered that prices of Herbalife products (based on the prices showed on Herbalife's official website or www.yhd.com) were in general higher than those of other products, but the proportion of its R&D costs to its revenues was lower than that of other products. According to Herbalife's official website, Herbalife's Performance Protein Powder (400g) is priced at RMB218 (RMB0.54 per gram). Conba's (600572: Shanghai) Proteins Powder (450g) is priced at RMB118.3 (RMB0.26 per gram), which is less than half of the price of Herbalife. Jiaoda Onlly's Protein Powder (275g ! 2) is priced at RMB109 (RMB0.19 per gram), which is also cheaper than Herbalife's similar product. Harbin Pharmaceutical's Protein Powder (350g) is priced at RMB118.3 (RMB0.42 per gram), which is also cheaper than Herbalife. In comparison with other manufacturers of similar products, what is the proportion of the R&D costs of Herbalife's relatively high-priced products to its revenues? Our reporter reviewed the 2012 financial reports of each of these companies and found that R&D costs to revenues proportion is 1.1%, 2.63%, 3.22% and 1.26% for Herbalife, Conba, Jiaoda Onlly and Harbin Pharmaceutical, respectively. Food products marketing expert Chen Siting commented on the above that, product price is determined not only by cost but also by brand value, economies of scale and many other factors. "From a marketing perspective, cost is not the sole determining factor of product price", said Chen. "What's more important is the consumers' recognition, i.e. the price at which the consumers are willing to pay for the functions and added values of a certain product." However, Chen also said that some enterprises may have exaggerated the functions and effects of their products so as to make consumers pay more. 5
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Loosely-Supervised Clubs In its multi-layered marketing network, Herbalife is proud of its club distribution channel. Herbalife's clubs create socializing opportunities. Everyday, sales representatives would bring their relatives and friends to the club for them to get product information and then purchase products. Pursuant to Herbalife's requirements, setting up a club requires reporting to and being approved by Herbalife. However, as all these clubs are independent legal persons, it significantly weakens Herbalife's supervision and management over these clubs and makes it difficult to regulate the distributors' illegal activities. Recently, one of Amway's distributors violated the rules and directly or indirectly caused the death of a consumer due to an excessive consumption of Amway's weight loss products. Amway did not consider itself liable for the consumer's death, claiming that it was the "distributor" which caused the death and it should bear the liability independently as an independent business entity. Similarly, in order to prevent troubles caused by distributors, Herbalife also built up a buffer zone between itself and the distributors. According to the rules of Herbalife, nutrition clubs are not allowed to promote themselves by using words like "chain store", "franchise" or "concession" and are not allowed to use the word "Herbalife" in their names. Insiders analyzed that such rule of Herbalife obviously aimed at separating itself from the distributors legally so that Herbalife could completely stay out of trouble in case anything happens to a distributor. However, in accordance with the Regulations on the Administration of Direct Selling effective as of December 1, 2005, a direct selling company shall be jointly and severally liable for the direct selling activities of its sales representatives, unless it can prove that the company has no connection with the direct selling activities of a sales representative. Therefore, the direct selling activities of a sales representative are directly related to the company, and the company cannot easily disclaim its responsibility. Sales Representatives Become Main Source of Consumers Many consumers do not buy Herbalife's products simply for the purposes of losing weight or keeping health. In many of its internal trainings, Herbalife has continued to obscure the line between consumers and investors. After attending several internal trainings of Herbalife and contacting some of its dieticians (sales representatives), our reporter found that their approach was quite similar to pyramid scheme. What they promoted at the beginning was an investment opportunity, but later you became a consumer yourself unconsciously. It raised our concern regarding the composition of the consumers of Herbalife. Are they consumers who simply want to buy health products, or sales representatives or 6
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potential sales representatives of Herbalife? In fact, in several Herbalife's internal training sessions, our reporter found that many people attended such trainings with an intention to make money. Li Ming, who developed our reporter as his customer, claimed that he had encouraged many of his relatives and friends to join Herbalife's direct selling team. In his opinion, this is a very promising business. Li Ming said, "I am going to bring my nephew into this business. His current job has no future at all." All the sales representatives whom our reporter spoke with claimed that they had bought and used Herbalife products. This shows that sales representatives or potential sales representatives have accounted for an important portion of consumers of Herbalife's products. According to Herbalife's 2012 financial report, it has approximately 3.2 million sales representatives worldwide. In China, it has 200,000 sales representatives, staff members and independent service suppliers. If members of such a huge sales force have all paid the "membership fees" in the amount of RMB12,000 per member, as requested by Li Ming, such membership fees would make up an amount as much as RMB2.4 billion in the PRC region. In addition, all the sales representatives that our report spoke with mentioned without exception that they have been taking Herbalife products for a long time while they are selling Herbalife products. In such case, the consumption by the sales representatives alone can generate a considerable amount of income for Herbalife. It is worth nothing that how much income of Herbalife comes from its sales representatives and how much income is derived from real consumers. We could not find the answer to this question in Herbalife's financial report. But based on our reporter's investigations on several nutrition clubs of Herbalife, there were not many real consumers, and on the other hand, almost all the sales representatives mentioned that they were taking Herbalife products. If a direct selling company is overly dependent on purchase made by its sales representatives, the income and profits of such company would also be dependent on its sales representatives. Once there are not enough members from the "lower level" to purchase the products, the existing sales representatives would not be able to make enough money but would have to spend a lot of money on the purchase of products and the opening of new clubs.

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