Friday, November 20, 2009

A Word on Publicly-traded MLMs and Pyramid Schemes

(Disclaimer: I am not a lawyer, and the information here is my understanding of various business models. Pyramid lawyers and representatives: please do not pester me with emails and comments.)

I have been following on a semi-regular basis several stocks of companies that operate as "MLMs" ("multi-level marketing"). They are Avon (AVP), Herbalife (HLF), Usana (USNA) and Prepaid Legal (PPD). There is a thin line between the legitimate and not-so-legitimate operators in the business: the FTC guideline is that if there is an overt focus on "recruitment" rather than selling the actual products/services to non-affiliated end-users, then the organization is most likely a pyramid, rather than a legitimate enterprise. Many operate in a cult-like fashion, preying on the gullible, promising riches, opportunities, success, and so on. They try to convince their recruits that the outside world does not understand them and that they are special, selected group.

A MLM turns into an outright pyramid when the demand for its products is generated mostly within the "system" (through forced sales to each "member") thereby necessitating the constant addition of new members not just for growth but just for maintenance. Once the world runs out of greater fools, the pyramid collapses, much like a Ponzi that runs out of new investors to pay off the old ones. The only people ever making any kind of money in these enterprises are the founders/top layer.

So this brings us to today's news that Pre-Paid Legal (PPD) has received a draft complaint by the Federal Trade Commission (the FTC) for its marketing practices for one of their so-called products. Their CEO and CMO are personally named in the investigation. This comes on top of a SEC investigation from early October. The stock was at over $50 then, now it is at $33ish. It should be lower in my view, and today's drop comes to no surprise to anyone who has followed this company for any lengthier period of time. I recommend Reggie Middleton's analyses (more links at the bottom of this latest piece), Robert FitzPatrick's report (pdf), Tracy Coenen's numerous posts on several schemes and Barry Minkow's "special" site on PPD.

PPD has been a difficult short because of their non-stop buyback efforts as well as the "all clear", until now, from the federal regulators.

PPD, for the uninitiated, sells "legal insurance" and, more recently, "identity theft protection." The sales are done by "agents" recruited by other agents. Agents are required to purchase the product, and then have to either recruit more agents, or sell the "insurance" to outside people. The products themselves are worthless, in my view. You can read about them all over the internet. This leads to an enormous churn, which has to be replaced by new recruits willing to suck it up for a year. The pdf file linked above shows the decline in numbers as it appears that PPD has simply run out of greater fools. I have been approached by PPD representatives twice in my life, once at a gas station in Utah, and once in a supermarket in Maine, and both times they talked to me about what an opportunity it is to have your own "sales" organization. In other words, recruit.

As an investor, here are my questions when analyzing a company of this sort:
(1) Is there an explicit limit to the "layers" in the MLM? Avon has those, I think. If there is no limit, then I'd be concerned.
(2) Product sales to agents vs. product sales to outsiders: are those disclosed? what is the ratio?
(3) Agent churn rates: do they seem excessive? Are they disclosed at all?
(4) Products/services: are those products that offer legitimate benefits combined with reasonable prices? Most products are not unique, really.
(5) How cultish is the enterprise? Do the agents get defensive and/or aggressive if you question the products or the organization during your research?
(6) How understandable is the accounting in the company's public filings? Is it difficult to track different classes of agents, actual unit sales, net agent growth and other operating metrics? If it is hard to understand, it is made hard to understand for a reason.
(7) Is management also on a "top" level in the scheme, and getting a cut from every new recruit 15-20 levels down the pipeline?
(8) Are agents required, without exceptions, to purchase "inventory" on a regular basis without regard to the agent's actual sales levels?
(9) How is the MLM marketed? Do they target certain isolated and semi-isolated groups, religiously, linguistically or ethnically, and why? I have been seeing a lot of central Americans recently with bags and buttons from a certain health food/beverage company.
(10) Actual sales figures per agent per Q or per year: are those disclosed? Are they fitting with the recruiting promises?
(11) What is the chatter on the company? Are there lots of upset former agents?

Remember, there is nothing inherently wrong with owner-operates small businesses as a part of a larger corporate enterprise. But most are single-level, with a territory manager and legitimate products: things like Snap-On tool trucks, independent bakery routes, Mr. Softee, Zee Medical cabinets, single-person franchisees and so on. The "agents" do not "recruit." They are focused on developing their own business with outside customers. There is no cannibalization, forced out-of-pocket inventory and the like. Franchising is highly regulated and is less likely to attract bad actors (there are some really bad business models, and some incredibly high fees, but that is a different risk). "Buyer beware."

P.S. I should also point out that I have studied PPD in grad school as an example of deceptive accounting (yes, they are a case study) from the late 90's-early '00s, and, more recently, I looked at their accounting again.

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