![]() Date: 2024-08-16 Page is: DBtxt003.php txt00011105 | |||||||||
Business Economics | |||||||||
Burgess COMMENTARY | |||||||||
Examining Business Plans: Value Extraction Vs. Value Creation Summary The MLM model is based on extracting value: companies succeed by customers losing. The TPO Rooftop solar model is based on extracting value, by selling the payments, not the investment. The Pharma model likewise is based on extracting value. The economics of sustainable business. It has always amused me that Bill Ackman loved Valeant (NYSE:VRX) and hated Herbalife (NYSE:HLF) - because they clearly both operate on the same fundamental premise. How can we extract maximum value from society without contributing any? Terrier Investing, 'Sell Herbalife before it ends up like Valeant,' on SA 3/20/16 Sustainable business has several major sets of stakeholders, shareholders, creditors, customers and employees, as well as the community at large. The only thing that makes a business sustainable is the fact that it creates value for all stakeholders. We are currently seeing what that means in the recent downgrade of Exxon Mobil (NYSE:XOM) with the exit of the Rockefeller fund: the divestiture of carbon-based energy became 'official' with the exit of the Rockefellers. The growth is now in renewable energy, even though too few have yet figured out how to do it profitably and sustainably. The last few years, I have had a ball with writing about Herbalife (NYSE:HLF) and the MLM problem, even though I originally started writing on this site about renewable energy, but when Carl Icahn (NASDAQ:IEP) went long Herbalife, the temptation was too much not to dive into that issue. Why anyone would want to bet on a legal death trap like MLM remains absolutely unclear, even if it seemed like a safe bet that regulators and law enforcement would continue to do little or nothing. Icahn clearly did not grasp the issues, let alone do a rational risk assessment. So far, Icahn has seemed right, but history is not on his side. The one theme that has stood out for me is the idea that business plans based on value extraction are unstable in nature. The philosophical counter point is that from a physics standpoint no business is sustainable, as indeed life is not, because of the second law of thermodynamics, a.k.a. entropy: nobody gets out of here alive and we live on borrowed time. Arguably, certain processes might be more destructive than others, and for the moment, releasing more carbon in the atmosphere seems like a bad idea. Hence the shift to 'renewable' energy sources. We better take it with a grain of salt, though, for everything has an environmental cost, including solar panels. For now, however, the pendulum is starting to swing the other way, and the externalities of carbon emissions are starting to impinge on the accounting of the energy industry. Extraction of value from the ground while putting the cost on society at large is now running into a wall. In the context of the relationship with customers, it is important that any business understand that it serves several stakeholders: its customers, its investors and creditors, its employees and society at large. Sustainability implies good marks in all those categories, or else it is likely to catch up with you in the end. From time to time, the picture is further clouded by regulations and incentives, and politics in any number of forms, but that is just so many little boys and girls with their fingers in the dike. Eventually, the economic forces cannot be dammed up forever, as is now becoming evident in big oil. In the end then, it is always about the economics. Third Party Owned Rooftop Solar PV I have written, on this site and elsewhere, about every possible reason why TPO rooftop solar PV is over-rated and often a bad idea. It is a form of consumer finance that uses deceit ('Sell 'em on the payments!') to make something seem cheap, which may not be an economic value in many cases (very often it has a negative NPV for the property owners), because simply stretching the payments to make it appear cheap is not a way to create value for the customers. Hence, we are now starting to see newer entrants like Sunworks (NASDAQ:SUNW), as well as a long-term player like SunPower (NASDAQ:SPWR) focusing on making money on systems, and the value proposition for customers. In short, the deceit of using finance to make something seem to be a value when it really is not, is used to extract value from customers, but eventually consumers will become educated, for other vendors will make them see the light, if nothing else will. Likewise, the deceit of customers implies misleading investors about the viability of owning the payments on those dubious consumer loans. Eventually, this issue plays into the shake out in the solar patch, starting with the Vivint Solar (NYSE:VSLR) and SunEdison (NYSE:SUNE) fiasco, but it impacts SolarCity (NASDAQ:SCTY), and Sunrun (NASDAQ:RUN) and others as well. At the political level, it would eventually have to become evident that it made no sense to create incentives that resulted in massive numbers of bad deals for consumers, but that is a long process. Consumers are finding out the hard way when they sell a property with a solar lease or PPA installed, and have to get it assumed by the new buyers. Many end up losing all their supposed 'savings' at that moment, and sometimes more. The bottom line is, the PPA/lease companies were based on value extraction: selling 20 years (or even the promise of an illusory 30 years) of payments to investors, aided by tax breaks, and economically unsustainable net metering rules, which respectively extract money from tax payers, and from electrical rate payers. The scheme is running out of steam lately. The real customers are the investors in this debt, and the apparent customers are simply renting their rooftop for someone else to go green, since the Renewable Energy Credits, or RECs are sold off in these transactions. The MLM/pyramid scheme value extraction model Historically, it is now clear how law enforcement and regulation went into a skid with the FTC's Amway '79 decision, by allowing that something that was clearly seen as fraud before, now was deemed at least conditionally legitimate, and, conveniently, the conditions that were listed as potentially preventing an MLM from being a pyramid scheme were nearly impossible to enforce, and the industry promptly drove a truck through that weakness. Some brilliantly straightforward reflections on the absurd history of the case were provided in private correspondence by Bruce Craig, a veteran of pyramid scheme prosecutions as former AAG in Wisconsin (with minor edits):
There's precious little to add to that. Law enforcement skidded off the road in 1979, as a reconstruction of the accident scene shows. Legal careers could have been based on examining the absurdity of that ruling. But the effect of the resulting stalemate has been that the clearly illegal fraudulent misrepresentation of MLM has now become normal and acceptable. For now, the FTC under Edith Ramirez has started to get the car back on the road with the recent Vemma case, but they have been inexplicably dawdling in the Herbalife case. The lessons of history are too easily forgotten... here are two articles on Glenn Turner and Koscot, with the Rice dwarves and F. Lee Bailey in tow: in the Orlando Sentinel, and New York Magazine. At a recent event in Chicago, organized by the University of Illinois in collaboration with SEC, with participation by the FTC, FINRA, et al., some valuable information was presented on the societal cost and the damage caused by MLM/pyramid schemes. Still, Andrew Ceresney, as Director of Enforcement for the SEC, managed to offer a speech, which got only some of the concepts right, but skidded on the banana peel of product sales, the favorite fig leaf with which the MLM industry covers up pyramid schemes. The confusion that the product matters ignores the fact that pyramid schemes are financial crimes-with or without 'real' products - that have been missed by law enforcement on a massive scale thanks to the decoy of product sales. That part of his speech sounded more like he was holding out a resume to the DSA, and the only saving grace lay in the disclaimer that this was just his opinion and he was not speaking for the agency. We could only hope so. The recent reports of the departure of FTC commissioner Julie Brill to a law firm that has the DSA for a client makes it clear that the issue of regulatory corruption is not moot. MLM and 'momentum' MLM survives by promoting a storybook version of how it works and why it is a 'business opportunity' in which all have the same chance. The reality of it is that MLMs get launched all the time by a small group of insiders who preposition themselves, and frequently with under the table deals, so these top dogs end up making all the money because program features such as roll-up, compression, and qualifications, along with compulsory consumption, ensure that the majority of commissions roll up to the small group at the top. Generally, the industry considers that these programs enter 'momentum,' when they have at least 100,000 distributors, which is the point when mathematically the opportunity for the new person joining is effectively near zero. The majority of the income in MLM rolls up to the top 1% or even 0.1% in any given year, but the rate of churn in the other 99% is 50% or higher, so that the winners are mostly constant, but the large numbers of losers who try their hand in vain every year slide down the greasy pole, and lose pretty much everything they spend, including expenses and time, and the only 'benefit' of participation is the potential tax deduction for this 'business'. To sum it up, MLM makes the bulk of its money on the hordes of people who fail to make it, and much like the carnival barkers promoting the greasy pole, or the shills of three-card Monte, the co-conspirators at the top of MLM make their money convincing the gullible (including regulators and law enforcement!) that the improbable is not only possible, but actually a desirable 'business opportunity'. How regulatory capture works Co-optation is undoubtedly the best form of regulatory capture, literally making the regulators a partner in crime, by having them buy in to some other benefit that could appear to partially or wholly supersede the harm, and have the effect of forestalling or even completely avoiding regulatory action. Just look at what is happening in food safety, to name one area. Favorites are always employment and other worthwhile benefits provided by the business. Herbalife has pitched that, and so has the rooftop solar industry. This is largely moot in many cases, since competent people can be redeployed, solar is not going away just because the rooftop variety is being over-hyped at the moment. Outright bribery is more rare, but bribery disguised as consulting fees (Albright) and speaking fees (Clinton, Bush, Trump, Carson, Romney) is a prevalent practice in the industry, seemingly socially acceptable, and it has generally provided for a steady supply of get-out-of-jail-free cards. Juicy jobs in the industry are a close second, as has been very visible in the way Herbalife has been stocking up on former regulators. It seems they had to open a fresh can of former regulators a few times a year since the Ackman short. For examples of regulatory capture, besides what is going on with MLM, it pays to look at what goes on with the nutritional advice (by the USDA serving the farmers, not HHS or FDA serving the public), as well as many of the examples below in the medical and nutritional areas. Also, the corruption of the 'organic' label by USDA is a worthwhile story to understand. The drug approval process of the FDA is another area of collusion, inadvertent or otherwise, as suggested below. In other words, the reality of government everywhere is that regulatory capture is the norm, not the exception, and the question always is: who polices the policemen, and how do you audit the system to prevent that stasis of regulatory capture, collusion and corruption. Failures of enforcement mean that criminal behavior is increasingly mistaken for 'normal'. The MLM case makes it clear that Harry Markopolos' comment is as valid today as when he first made it in the Madoff case: the regulators are protecting the crooks from the consumers, not the consumers from the crooks, and the same goes in many areas besides the FTC and SEC. The role of counter-productive tax breaks In both of these cases, MLM and TPO rooftop SPV, tax breaks play a role, and they distort the picture tremendously. In TPO rooftop solar PV, it is the bad design of both the tax incentives, and the feed-in tariffs which has distorted the market and enabled the raw deal for consumers, in which not the value added to the property, but the deceptive and deliberately falsified analysis of 'savings', simply tricks consumers into signing for 20-year PPAs and leases, even if it does not make financial sense. (Note: rather than argue there should be no incentives, I would propose they should be geared to results, not spending.) In MLM, companies are trying to promote what amounts to no more than an illegal lottery in which the house always wins, by promoting it deceptively as a 'business opportunity', even though the chances of success are effectively zero, as Robert L. FitzPatrick recently highlighted in this article, prompted by the release of the movie 'Betting on Zero.' The bottom line is that the industry data tend to misrepresent the actual 'opportunity', even if it is taken into account that less than 1% make any money, and 99% lose money in any given year, because the 1% are relatively constant, and the majority of the 99% fresh victims every year. The result is the new recruit effectively has a zero chance of ever making reasonable money, let alone approaching what the guys and girls at the top make. In short, it is not just that FTC, SEC, and DOJ are enabling the continuation of the MLM/pyramid scheme business, but the IRS plays a supporting role as well. The role of the IRS as an unintentional endorser of this form of fraud lies in accepting these tax deductions. As Bruce Craig noted (above), the cost of personal consumption is often deducted by many as well, because the real business is the pyramid scheme, not the distribution of product... product is also often given away as free samples. Instead, if MLMs were treated like a form of illegal gambling, expenses should not be deductible unless someone clearly made their living at it, and MLMs would be committing tax fraud if they promoted the tax-deductibility of expenses. In short, the organizers of an upcoming forum on tax justice might do well to include these issues:
The medical industrial complex At this point, Martin Shkreli and Michael Pearson (Valeant) are merely poster boys for the greater issue of the total dysfunctionality of the unsustainable big pharma model of medicine, in which disease management is profitable and healthcare is not. Value extraction is the name of the game, from the consumers directly and indirectly (via medical insurance), and also via taxes. I will cite some observations in bullet form:
In short, much of the medical industrial complex extracts value based on fear, but de-facto enables the perpetuation of the SAD diet and the resulting health problems. In this case, there may not be deliberate deception, but cultural blindness - the paradigm is wrong. Recently, major funding was announced because we have a 'crisis' with heroin overdoses at 78 per day, but somehow 1675 CVD deaths per day, as per the CDC data, are just business as usual, and we continue to publish a food pyramid that protects the dairy industry, and not the consumers. Still, it is fairly clear to growing numbers of people that milk is food for baby cows, and not people. Conclusion Value extraction and treating customers as victims to be plundered does not make for a stable business, whereas providing value does tend to create repeat business. In MLM and TPO rooftop solar, the consumer deception is very overt, though the MLM variety is more clearly illegal if it is understood as a pyramid scheme hidden behind the apparent product sale. In rooftop solar, it is more like the used-car sales pitch of selling people on the payments, so they don't focus on the price of the car. In the medical, for-profit-disease-management scenario, irrational fear is exploited to extricate exorbitant amounts of money from consumers, and frequently by ignoring or obfuscating the obvious solutions. All of these are paradigms that are very fragile, because once understood, the customer can simply decide against them. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
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