Ladders, Losers, and Direct-Marketing Schemes

A skin cream customer pays an extra fee and, voilà, instantly becomes a company representative with the right to sell cream and other products, as well as recruit more dealers.

Eventually, she persuades other women to buy the cream and join the marketing team by paying the fee. Each newcomer is encouraged to find more followers, growing the cream distribution network one recruit at a time.

Meanwhile, comfortably positioned atop the sales ladder’s highest rung, is the very first product dealer. He or she gets a percentage of all revenue generated by the growing number of lower-rung sellers busily pitching products around the world.

That’s a short description of the marketing scheme that a Beijing woman surnamed Zhou joined to sell personal care products made by Nu Skin Enterprises Inc., a Utah-based company listed on the New York Stock Exchange that uses a multi-level marketing system to sell creams, nutritional supplements, and other personal care products in countries including China.

Nu Skin’s China market is expanding fast and has become all the more important in the face of slowing growth at home. In the fourth quarter 2012, according to Nu Skin’s financial report, sales in the greater China region (including the mainland, Hong Kong, Macao, and Taiwan) rose 28 percent year-on-year to US$141 million. U.S. sales for the same period totaled only US$80 million, a 4 percent increase.

Since mainland sales alone contributed 12 percent of the company’s US$588 million in global revenue last year, there was no surprise when company CEO Truman Hunt recently promised to focus on doing more business in China.

In a conference call with major shareholders, Hunt said the company would strengthen China investments and boost annual sales in the greater China region to US$1 billion by the end of 2014.

But Hunt’s grand ambitions for China have raised questions and stirred critics. Although Chinese commerce agencies have so far had no qualms about Nu Skin, some domestic critics of the company’s multi-level marketing strategy claim it violates Chinese law.

Meanwhile, investors mainly in the United States who’ve taken a negative position on Nu Skin’s value are short-selling its stock. They say the marketing system in China and alleged breaches of U.S. drugs regulations are among the reasons why they think Nu Skin share prices will fall.

A Nu Skin spokesman defended the company’s China operations, saying the company would take steps to cut off any employee who breaks the law. He added, however, that the company was working to properly structure its Chinese business, which is unlike operations in other countries, to fit domestic regulations.

Still, Nu Skin’s critics are pressing for changes in the multi-level marketing scheme that attracted Zhou and others across China. There are, for example, debates and discrepancies concerning dealer recruitment.

Nu Skin says it charges a one-time fee of US$25 per person who wants to become a permanent distributor. But Zhou says that’s an understatement. To qualify as a distributor, she says, Nu Skin requires sales of at least 30,000 yuan worth of products in a six-month period. And that period starts all over again if one month’s revenues are less than 5,000 yuan.

New recruits earn a commission equal to 10 percent of sales which, based on the expected base of 5,000 yuan, could be a meager 500 yuan. Zhou said that much money would barely cover a dealer’s transportation costs.

Despite this and other drawbacks, the system promises tempting rewards. Zhou said a distributor can earn commissions between 20 and 25 percent on all sales generated by dealers at lower levels of the marketing ladder. “Your paycheck depends on the sales performance of everyone you introduce” to the network, she said.

A Nu Skin manager’s bonus is primarily calculated based on the number of subordinate distributors and sales agents, according to another Beijing distributor. A manager’s attitude toward customer service is also factored in, although it carries much less weight in the bonus-calculation process.

Among bottom-rung dealers, however, the vast majority earn little or nothing. Jon Taylor, whose non-profit Consumer Awareness Institute is also based in Utah, said more than 87 percent of Nu Skin’s active distributors worldwide earn nothing, and 6.5 percent average only US$492 a year.

The big winners in this marketing strategy, he said, are those looking down from the top rung of the hierarchy. The company calls them “blue diamond distributors,” and they’re paid annual commissions of up to US$582,000.

Nu Skin is not the only company in China running a cascading marketing scheme, said Li Xu, chairman of the China Anti-Pyramid Promotion Association, a non-government organization that promotes market fairness. Altogether, the Ministry of Commerce has licensed thirty-three direct-marketing Chinese or foreign-invested companies. Each has a multi-level marketing structure similar to Nu Skin’s, he said.

A pyramid scheme under Chinese law has an incentive mechanism through which a sales agent’s compensation is calculated according to the number of people he or she introduces to the network and that person’s sales performance, Li said. On the other hand, the law stipulates that for a direct-selling scheme all payments must be based on an agent’s individual sales to customers and that total remuneration, including commissions and bonuses, must not exceed 30 percent of his or her sales revenue.

Li’s interpretation is that the law prohibits the multi-level dealer network-type of marketing, which means in his eyes companies like Nu Skin are breaking the law. However, only one company to date has had a direct-marketing license revoked in China, and the reason had nothing to do with marketing.

Losing its license in 2006 was Zhen-Ao Pharmaceuticals Co. Ltd., based in Dalian. The commerce ministry found it had lied on its license application.

Neither Nu Skin nor any other licensed direct-marketing companies have been mentioned as problematic by government officials. But a hint of trouble was heard about a year ago when Zhang Guohua, chief of the direct-selling bureau at the State Administration for Industry and Commerce, reportedly said in May at a government work conference that “a few direct-selling enterprises do not cherish their hard-won licenses ... and some of their businesses have morphed into pyramid schemes.”

Yet regulators generally find it difficult to enforce laws and go after alleged violators. One reason, said Li, is that direct-marketing license holders usually have “strong public relations.” Moreover, gathering evidence to prove a violation can be difficult.

“These are some of the factors that explain why illegal behavior slips through unregulated,” Li said.

Another red flag fluttering over Nu Skin’s operation in China is related to the fact that, under Chinese law, a direct-marketing company is not allowed to hire professional health care workers for a sales force. Yet the company’s China sales director is Zhao Hongwei, who calls himself a medical expert. Organizers of Nu Skin sales campaigns tout his medical credentials, while he says the development of Nu Skin products represented “a more significant breakthrough” than penicillin’s discovery.

Short-sellers of late have started chasing Nu Skin. A prominent attack was led by Citron Research, which last August questioned the firm’s China marketing and claimed an “apparent violation of FDA (Food and Drug Administration) and/or FTC (Federal Trade Commission) regulatory laws in the U.S.”

Citron’s report also accused Nu Skin of “lying about a scientific research relationship with Stanford University for their flagship technology AgeLOC.” After the report’s release, Nu Skin’s stock price fell to US$36.70 from US$44.80 per share September 13. It later picked up.

A sideways threat came December 18, when American hedge fund manager Bill Ackman questioned the marketing system used by U.S.-based Herbalife, a global seller of nutrition and personal care products that recruits marketers in much the same way as Nu Skin. Herbalife’s share price lost 12 percent that day, and Nu Skin’s ended 9 percent lower.

On the day of Ackman’s report was released, Nu Skin said it would hike 2012 dividends 50 percent. Its share price soon bounced back. That announcement followed an April 2012 outline of a US$250 million share buy-back scheme, punctuated by Nu Skin’s promise to consider future buybacks and step up dividends.

Managers at two U.S. hedge funds who declined to be named said they’re also shorting Nu Skin. One cited the marketing structure in China as the primary reason for his position.

Nu Skin has given no indication of any plan to change its marketing techniques in China. For Zhou and other distributors, that’s likely to mean a lot of toil for the slim chance of a big reward.

Yet that ultimate prize is driving Zhou and others to work hard for Nu Skin in China. She said it’s her dream to someday make money “even when there’s no work being done.”

Washington correspondent Tang Jiajie contributed to this report