Editor’s note:  Herbalife has argued that the business model has changed over time, specifically that new distributors are not pressured to buy loads of product upfront to achieve sales leader status, a process known as qualification buying. They say more and more distributors buy smaller amounts of product over longer periods of time, proving that customers really are interested in buying the product for self-consumption. Richard’s own investigation into South American nutrition clubs shows how the scam has simply morphed. Distributors enter training programs and are required to space out purchases to maintain participation in the programs – thus creating an illusion that things have changed even though aspiring entrepreneurs are still required to make purchase after purchase to stay involved.

Christine Richard Herbalife’s Misleading Lesson About The Collapse Of Qualification Buying by Christine Richard

Christine Richard is the President of Orion Research LLC, which does investigative research for investors. She is a former reporter with Bloomberg News and Dow Jones and the author of Confidence Game: How Bill Ackman Called Wall Street’s Bluff (Wiley, 2010). Pershing Square Capital Management, which has a short position on Herbalife, is a client of Orion Research LLC.

Summary

Herbalife says fewer of its distributors are engaging in so-called “qualification buying”.

Instead, distributors make smaller, more frequent purchases, purportedly proof they’re buying from Herbalife to service retail customers.

That’s important because the judge in the FTC’s case against Vemma says evidence of qualification buying is “evidence of a pyramid scheme.”.

We follow a Colombian Herbalife distributor enrolled in a popular training program called “Escuela 500” to show how his smaller more frequent purchases have nothing to do with retailing and everything to do with qualification buying.

Percentage of Herbalife Supervisors Qualifying in Two Months or Less

Herbalife

Over the last several years, Herbalife Ltd. has been telling investors about a significant and positive change in its business: Fewer distributors are signing up and immediately purchasing the 4,000 volume points worth of products. Instead they become Supervisors more gradually, taking three to 12 months to purchase 4,000 volume points as they build a sustainable base of retail customers.

Nothing could be more important to the survival of Herbalife’s business than proof that so-called “qualification buying” is vanishing from the company’s business. The Federal Trade Commission is pursuing a case against competing multi-level marketing company Vemma and has criticized that company’s reliance on qualification buying. Vemma requires distributors to make an upfront purchase of $500-$600 worth of products and then to sign up for auto-shipments of $150 worth of products every month in order to earn commissions.

The judge in the Vemma case said:

“Evidence that distributors purchase and consume product for the purpose of qualifying for recruitment incentives is evidence of a pyramid scheme.” (Source)

Herbalife’s Qualification Issue

Herbalife’s marketing plan also encourages qualification buying. Herbalife requires distributors to buy 4,000 volume points to become Supervisors, a designation that allows them to receive commissions on purchases by those they recruit. Then they need to buy 2,500 volume points per month to maximize those commissions. One volume point costs roughly $1.

Instead of eliminating these controversial- and expensive- qualification requirements, Herbalife is attempting to convince investors, regulators and the public that distributors are not really influenced by them. Herbalife claims distributors are no longer talked into placing one or two large orders to immediately qualify as Supervisors. Instead they march to a different drummer when placing orders with Herbalife- demand from retail customers. This demand results in smaller and more frequent orders that allow a distributor to qualify over time- without ever engaging in disreputable qualification buying. (Herbalife says it has encouraged this transition by extending the time available to purchase the 4,000 volume points from one month to 12. It has also limited first-time orders to $1,000 or less.)

The argument seems convincing. Fortune Magazine’s Roger Parloff picked up on this in his recent article The Siege of Herbalife:

Throughout the Johnson era, the size of the average purchase has been getting smaller, while the number of orders has been increasing. Though the impetus for the changes was apparently not regulatory, its impact could be. While inventory loading seemed like a plausible charge when new recruits were being pressured to buy $3,000 worth of products in a month, it seems less so in a company that, since 2007, has actually been exhorting new recruits to slow down their purchasing.

One reason Parloff is convinced is because the former director of the FTC’s Bureau of Economics, Dr. Joseph Farrell, is convinced.

Parloff quotes a 67-page report authored by Farrell in which the economist concludes that there is consumer demand for Herbalife’s products. Although the report has never been made public, according to Parloff, the economist concluded that “purchasing patterns were consistent with the purchasing you’d see when distributors were fulfilling consumer orders and not gunning for bonus qualifications.”

To summarize the argument: It’s not necessary for Herbalife to prove it has retail sales if the company can show that its distributors buy from the company in a way that “proves” they have retail customers.

But are these slow and steady 3- to 12-month qualifiers really distributors with retail customers? Let’s meet one.

Escuela 500 Tuition Payments

Last summer we highlighted the importance of training and certification programs to Herbalife’s business. We explained how these programs, including one of the most popular called Club 100, turn recruits and their family members and friends into conscripted consumers of the company’s products as the recruits attempt to qualify to open their own Nutrition Clubs. You can read more about Club 100 here.

A few months ago we decided to follow up on our Club 100 research by looking at another popular program called Escuela 500. The program appeared to incorporate aspects of Club 100- including the various shake and tea consuming activities required for certification and the requirement that distributors complete the training program before being allowed to open a Nutrition Club.

We asked a recent enrollee of the program in Bogota, Colombia to send us regular updates.

One of the first messages we got from our Escuela 500 student was an explanation for the name of the program. His message was headed: “Important.”

“To qualify to School 500, as part of the certification process, you must make one or more personal purchases of a minimum of 500 pts. So you have from the 1st to the 31st of each month to complete at least that amount for the next month so you can attend the training. So if you decide to make the purchase in October, you will be qualified for November.”

Product-based tuition payments!

Escuela 500, it seems, adds a twist to Club 100 by requiring that distributors not only consume products daily in Nutrition Clubs but also place substantial orders directly with the company in order to participate in this training charade.

Our Escuela 500 enrollee sent the following after his first day of classes:

“I arrived at 2.00 pm to the venue, a Christian church auditorium for more than 2000 people, located in the centre of Bogota, where a massive queue of persons were waiting to register to this event. The price for the event ticket was US$15 for

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