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Herbalife: Pyramid Scheme or Juggernaut? CEO Michael Johnson Fights Back


Herbalife: Pyramid Scheme or Juggernaut? CEO Michael Johnson Fights Back

Photograph by Travis Rathbone for Bloomberg Businessweek

On Christmas Eve last year, Herbalife (HLF) Chief Executive Officer Michael Johnson’s mobile phone rang as he was walking into church. It wasn’t Santa Claus. It was Carl Icahn, who was in the first stages of building a stake in Herbalife, which had just been called a pyramid scheme by billionaire hedge fund activist Bill Ackman. The stock had plunged, and the sharks were circling. “He was feeling us out. He was kind of poking me,” Johnson says.

“For guys like that, trouble is opportunity.”

Still, it was Christmas Eve, on the way into church. “Put down the phone,” said his wife, giving him the old flat-handed cut-him-off signal.

Five days earlier, Johnson and 20 Herbalife executives, lawyers, and consultants had packed into a conference room at the company’s headquarters, a bulky concrete-and-glass building next to the Staples Center in downtown Los Angeles. They were watching a live feed of a presentation in New York by Ackman, who runs Pershing Square Capital Management. In three and a half hours and 340 slides, he massacred the company.

The root of Ackman’s charge was that Herbalife made the majority of its $4 billion in revenue not from sales of shakes, meal-replacement bars, vitamins, aloe drinks, and cosmetics to customers but from the continuous, exponentially growing recruitment of new distributors, who in turn recruit more. The products, sold at inflated prices, are a proxy for a fee to join the expanding network. Distributors at the top get rich on the recruitment efforts of the ones at the bottom.

At one point, Ackman estimated that more than 90 percent of the profits earned by distributors come from recruiting. “Our jaws hit the floor,” Johnson recalls. “Nobody threw anything at the screen, but there were a lot of cat calls in there like, ‘Are you kidding me? Can you believe this? That’s just a lie.’ ”

Later, Johnson and his officers watched the television as Ackman took to the airwaves to press his case. “It is a certainty that this company is a pyramid scheme,” Ackman told Bloomberg TV anchor Erik Schatzker. “I would not say that if I did not believe that to a 100 percent confidence level because I understand the implications of saying publicly a company is a pyramid scheme if it’s not.”

Ackman had sold short more than 20 million shares of Herbalife, a bet worth more than $1 billion, having bought in mostly between $50 and $70 a share. The stock would fall 39 percent over four days. Johnson, responding to Ackman in a statement, was unequivocal: “The allegation that Herbalife is a pyramid scheme is bogus.” The blood in the water drew attention from Wall Street. Icahn began buying shares and would later predict “the mother of all short squeezes,” referring to the Wall Street practice of pressuring short-sellers by driving up the price. On Valentine’s Day, he would announce he owned 13 percent of Herbalife, calling it a “legitimate business model with favorable long-term opportunities for growth.” About the same time, Daniel Loeb’s Third Point piled in with an 8.2 percent stake. Greenlight Capital’s David Einhorn, who sent Herbalife down 20 percent in May 2012 after asking about the company’s disclosures on a conference call, didn’t stick around after Ackman’s presentation. He cashed out his short position by year’s end.

Herbalife’s shares have since traded between $26 and $51, as Herbalife fought back and met more bad news. In the second week of April, Herbalife’s shares fell again after an outside auditor quit because one of its partners leaked rumors that the company would go private. The company has since hired a new auditor.

“These stories sometimes that we’re hearing today are 20 and 30 years old,” says Johnson. “For God’s sake, give us a chance to change. We’ve had some mistakes along the way, but that doesn’t say we’re a corrupt organization by any means. It’s really insulting to see the stuff that’s coming out and being taken as the truth because of one person’s financial motivation.” When asked if the company has ever been a pyramid scheme, Johnson says simply, “No.”

Herbalife products aren’t sold in traditional stores. They’re distributed by 3.2 million independent contractors who market to family, friends, neighbors, and just about any stranger they come across, typically in that order. The distributors can make money by buying product at a discount and selling it at a markup, but the bigger payoff comes when distributors broaden their reach by recruiting, training, and coaching a “downline” sales team to sell products to friends, neighbors, and strangers, earning them a complex web of royalties and production bonuses. The sales method and byzantine compensation system can leave an outsider with more questions than answers. A judge in Belgium looked at the system and concluded it was a pyramid scheme. Herbalife says the ruling contained factual errors and is confident it will be reversed.

As Ackman, who would not speak on the record for this story, puts it in his presentations, the big question is whether Herbalife is really in the business of selling a product. At Herbalife’s offices and plants, there is little to suggest that it is a virtual company, though a tour through a busy factory doesn’t say anything about sales. A massive Herbalife sign hangs outside the headquarters in Los Angeles, where about 200 people work; inside, it’s often busy with ceremonies inducting high performers into an array of distributor levels with names like Founder’s Circle and Chairman’s Club.

CEO Johnson at Herbalife’s headquartersPhotograph by Nathanael Turner for Bloomberg BusinessweekCEO Johnson at Herbalife’s headquarters

At Herbalife’s primary distribution center, 16 miles south, individual distributors arrive to pick up the product they ordered online. As many as 30 percent of the 4,500 orders a month from the facility are collected here, saving the distributors shipping and handling. (Ackman contends shipping and handling is overpriced and a major profit center for Herbalife. Herbalife denies this.) On a recent weekday afternoon, a steady stream of distributors, many Latino, flowed in and out of the building. The center is one of two primary distribution centers in the U.S., supported by eight smaller ones around the country and hundreds more around the world.

As for manufacturing, one of Herbalife’s plants is about an hour from headquarters, in Lake Forest, Calif. The 120,000-square-foot plant, in production since December 2010, pumps out as many as 140,000 plastic canisters a day of Herbalife’s mainstay, a meal-replacement shake powder called Formula 1, along with aloe drink concentrate. Herbalife operates two additional plants in China and is spending $130 million to build another in North Carolina to handle the eastern U.S. The balance of products are manufactured at 40 contract sites scattered across the globe.

There’s also a sprawling research complex in Torrance, Calif., that employs 1,300, including 50 chemists who analyze ingredients and finished products, test shelf stability, ensure the quality of active ingredients, and research new products. “Quality control is very important, and that’s part of what we’re selling,” says Bill Frankos, Herbalife’s senior vice president of product compliance and safety, who joined the company in 2010 after retiring from the U.S. Food and Drug Administration, where he directed its dietary supplements program. “You pay a premium for that.”

Ackman has taken issue with Johnson’s claim that the company performs research around the clock, pointing out in his presentation that Herbalife reported research and development spending in 2011 that was “not material.” Herbalife says Ackman has missed a key point. Its biggest product, Formula 1, is classified as a food, not a supplement or pharmaceutical, requiring different disclosure. Herbalife says it spent $44 million last year on R&D, quality assurance, product safety, and compliance.

At the Torrance lab, Frankos gives a short tour, pointing out what he says is a $200,000 gas chromatography mass spectrometer used to quantify fatty acids, such as in fish oils, and detect solvents that are sometimes used in botanical extraction. Other devices in the lab detect any heavy metals, such as lead and arsenic, or test for irradiated materials that are illegal in the U.S. Herbalife products, says Johnson, are made up of more than 1,000 raw materials, which have to be screened as authentic and to ensure they perform as advertised. Herbalife also maintains labs at its L.A. production plant and in China.

Michael Swartz, an analyst with SunTrust Robinson Humphrey (STI) in Atlanta who has toured Herbalife’s California facilities, says he found it hard to believe it was all an elaborate facade to create a cover product for a pyramid scheme. “I have no doubt people are consuming the product,” says Swartz, one of seven analysts who recommend buying Herbalife shares. Three others tracked by Bloomberg recommend holding; none say sell.
 
 
Herbalife’s founder, Mark Hughes, was a high school dropout who started selling herbal products in 1980, telling people his mother had died from diet pills trying to lose 30 pounds. He wanted a more natural solution, Hughes would preach to recruits. Years later, uncovered coroner’s reports would show she died from an overdose of a narcotic pain reliever.

Hughes’s shadow still falls over Herbalife. He was hauled before Congress in 1985 for hearings into mysterious deaths linked to weight-loss pills, and in 1986, Herbalife agreed to pay $850,000 to settle a civil suit filed by California officials accusing it of making false medical claims in promoting its products. It did not admit wrongdoing. In 1987 an FDA labeling probe also led Herbalife to stop selling a couple of pain relievers.

In May 2000, shortly after Herbalife’s 20th anniversary, Hughes, then 44, was found dead in his home with a blood alcohol content of 0.21 and toxic levels of doxepin, a treatment for depression and sleep disorders. According to his autopsy, Hughes had been drinking for four days straight. The death devastated distributors and sent the company into chaos. Four CEOs came and went in three years, and sales growth stalled. The company’s largest distributors were selling “work from home” businesses fueled by the Internet and recruiting scores of distributors who left about as fast as they joined. Herbalife was taken private by Whitney & Co. and Golden Gate Capital in 2002. A year later they would bring in Johnson, then president of Walt Disney International (DIS), where he had worked for 17 years. Johnson, a father of three, avid cyclist, and an amateur triathlete, was known as the “shake guy” at Disney because he liked to mix Odwalla (KO) smoothies with protein powder.

The first time Herbalife’s private equity owners asked Johnson to consider becoming CEO, he declined. “The image was a little, let’s be honest, challenged,” Johnson says. “When you said Herbalife to somebody, you could get a rainbow of responses.” On a second pass, Johnson agreed to a 45-minute meeting that stretched to six hours as the owners appealed to his obsession with fitness and his desire to run his own show. He became convinced Herbalife “could be taken in almost any direction,” he recalls. “I felt a kindred spirit with the product.”

Johnson also did his research. A fair amount of people actually used the products, he discovered, and the distributors were, in his view, loyal, motivated, and enthusiastic. Johnson says he liked the distribution model, too—people losing weight and encouraging those around them to do the same, face-to-face, outside a retail world filled with disengaged minimum-wage workers. He started to see blenders full of upside in emphasizing Herbalife as a nutrition leader while downplaying its get-rich-quick message. His wife still needed convincing: “She was in love with Disney,” Johnson says. “She wanted me to think long and hard about leaving.”

Along with recruits from Disney and the nutrition company Rexall Sundown, Johnson says he has remade the company. He’s implemented rules to focus distributors more on selling product and less on easy riches. He has embraced and nurtured the rise of nutrition clubs—once controversial within distributor ranks—that more closely resemble a retail sales model. Started by a distributor in Mexico, the clubs serve as a hub for distributors and use weight-loss challenges, health coaching, and other tactics to attract customers and get them to use Herbalife products daily. A student of branding at Disney, Johnson has plastered the Herbalife name on everything from pro soccer jerseys to race cars.

Net sales during Johnson’s tenure rose to $4.1 billion last year from $1.2 billion in 2003. But if he hasn’t earned mainstream respect, at least he’s earned money. His total compensation in 2012 was valued at about $10.3 million. In 2011 he exercised a batch of stock options and earned almost $25 million.
 
 
The important question, regardless of how Herbalife products are engineered or made, is: Who’s buying? Ackman dismisses the idea that there could be any legitimate demand for Herbalife products. He describes them as commodity goods without any special attributes, sold at prices that would never appeal to a retail consumer.

Because Herbalife doesn’t track sales from distributors to non-distributors, claims that it sells more product inside its system than outside have been hard to prove or disprove. Herbalife seems comfortable not knowing exactly what is happening, arguing that its business is selling to distributors who then sell to customers, as many food and beverage companies do. Distributors are independent contractors who own and manage their own customer data, Herbalife says. Requiring such information from distributors, it says, would be like Heinz requiring Costco to know what happened with every bottle of ketchup it sold.

In response to the hedge fund attacks, Herbalife has commissioned some studies. Last year the company asked Los Angeles-based Lieberman Research Worldwide to track use of and interest in its products. In October, Lieberman surveyed 2,000 people intercepted on mainstream websites, a common consumer research technique. The respondents, unpaid volunteers, answered five questions, including whether they had heard of Herbalife, ever purchased the products, or would be likely to buy them. Recent buyers were also asked whether they were distributors, says Lieberman researcher Kim Rory. Five percent of respondents, or about 100, had purchased an Herbalife product within the past three months. Of those, 91.6 percent said they weren’t registered distributors.

Herbalife presented a summary of the study at an investor meeting in January. Ackman dismissed it as biased and flawed, asking why the company can’t get precise records on the sales of distributors. Herbalife has since released the study to Bloomberg Businessweek and made executives and researchers available for questions. Bloomberg asked two independent research firms to evaluate the results. Both said Lieberman was a reputable researcher and concluded the sample size was large enough to generate valid results. “I don’t see any red flags,” says Jay Myers, a market researcher for New York-based Interbrand (OMC) who reviewed the study. Swartz, the SunTrust analyst, says if the survey is to be believed, it pulls the rug out from under most of Ackman’s Herbalife claims.

In its January meeting, Herbalife also said it had cross-referenced its database of registered distributors with another database of addresses collected when Herbalife directly ships products to customers. They found that about 1.1 million orders went to non-distributors last year. Those non-distributor shipments represented 25 percent of the total orders shipped in the U.S., Herbalife President Des Walsh said then, suggesting many more were buying Herbalife’s products as users than Ackman believed.

Ackman has pointed out that distributors agree, in forms they must complete to get royalties, to keep receipts proving they made 10 sales to 10 different customers each month. Given these receipts, he’s asked why the Lieberman study is necessary. Despite the importance of whether the company is really selling products or business opportunities, Herbalife has announced no plans to further investigate its own sales.

Johnson says he understands that the company’s broad use of the term distributor creates confusion about who’s really buying the product. Regular consumers of the products routinely sign up as a distributor to buy at a discount, even though they have no plans to sell products to others. Herbalife has announced plans to call those buyers something else, such as “preferred customers.” It’s taking longer than the company had hoped, as it negotiates with existing distributors over how to make the changes. To help with such cultural shifts, Herbalife has hired a head of global marketing and distributor insights, a new position with a mandate to improve understanding of “behaviors and preferences.”

Another plan is to better publicize triggers within Herbalife’s compensation plan that it says work against a pyramid model. Once a distributor sells more product than the person who recruited him, that recruiter no longer earns certain royalties. Johnson and his executives also say they have a team of 250 people who monitor distributor behavior to weed out rule breakers and maverick quacks.

Johnson acknowledges that Herbalife’s strength, its independent distributors, can also create liabilities. Anthony Powell, to take one example, had been selling Herbalife products for 22 years and was one of Herbalife’s biggest distributors when he left in January for energy drink maker Vemma Nutrition, another direct seller. In a video announcing the departure, he took on the tone and energy of a prosperity preacher as he encouraged his “downline” of 16,000 distributors to follow him. “This is going to be the biggest explosion in network marketing history,” said Powell.

Other top distributors have run side businesses selling sales leads and “business methods,” such as a suite of tools including chat- and sales-tracking software, to colleagues to help them boost sales. Under Johnson, Herbalife has banned distributors from owning such companies. Complaints on the Internet and in regulatory filings often detail grievances related to these business services, which advertise themselves as “work-at-home” opportunities.

Batting around Herbalife’s shares has proven profitable for the players. The stock is down from where Ackman started and above where Icahn bought in. Icahn has increased his Herbalife stake to more than 16 percent. Based on conservative estimates, he has generated a 20 percent return as of May 17, and Ackman’s bet has returned almost 9 percent. As recently as mid-March, Ackman’s paper return was about 22 percent. Loeb cashed out his stake in the first quarter for as much as $102 million.

Last month, Johnson sat in his office in a collared black shirt with a green Herbalife logo on the breast. His slacks, belt, shoes, socks, even his watchband, were black, too. One wall of the generously windowed office is full of products for demos and guests. Johnson’s bike, which he uses to commute the 30 miles home some days, is held upright by a fancy stand in the middle of the room. If he wasn’t relaxed, he was doing a good job pretending. He joked about writing a book, saying it will be one of the great business stories. “I’m pretty confident I know what’s going to happen,” he said. “We’re still going to be here 33 years from today.”

Stanford is a reporter for Bloomberg News in Atlanta.

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Companies Mentioned

  • HLF
    (Herbalife Ltd)
    • $43.25 USD
    • -0.14
    • -0.32%
  • STI
    (SunTrust Banks Inc)
    • $39.29 USD
    • -0.38
    • -0.97%
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