Manufacturers seek end to 'grey market'

Manufacturers have been dealing with product diversion for at least two decades.

clorox (photo credit: Bloomberg)
(photo credit: Bloomberg)
Private investigator Michael Kessler traveled to Honduras to track down some bleach. The bleach's manufacturer sent him to investigate how its merchandise, sold to a Central American distributor, kept showing up in US stores at a higher price, cutting the maker out of the increased profit. Kessler arrived at the purchaser's address only to find a gas station selling tires and chickens running across a dirt road. No buyer. No bleach. "That bleach did what we call a U-boat," said Kessler, president of Kessler International in New York, who declined to identify the brand. "It was shipped from the US to Honduras and went right back to the US again." Sleuthing is one way consumer-goods makers such as Procter & Gamble Co. are fighting back against a growing market for trafficking genuine goods outside of official distribution channels. The practice, known as product diversion, siphons as much as $63 billion of US industry sales, according to Deloitte LLP, the New York-based consulting firm. Product diversion exploits the different prices manufacturers charge in various parts of the world, said Pat Conroy, head of US consumer products for Deloitte & Touche USA LLP. For example, a distributor might buy a perfume a manufacturer sells for $10 a bottle in Asia, and resell it to a US retailer for $15. The retailer then sells the perfume for $20, undercutting the producer's official US price of $25. Deloitte estimates a manufacturer with $10 billion in annual sales can lose as much as $450 million to product diversion. That means the practice potentially costs makers of consumer products as much as 4.5 percent of sales in the $1.4 trillion US market for goods ranging from fertilizer to milk to razors, according to Deloitte. Manufacturers have been dealing with product diversion - also known as the gray market - for at least two decades. The companies can't always take legal action against the practice because the goods are legitimate and not stolen. As a result, they resort to using investigators such as Kessler and other tactics. They also add non-harmful dyes that are restricted in the US or change the packaging on goods destined for overseas locations, giving themselves grounds to sue distributors. Kessler, who started his firm in 1988, has tracked down diverted soups, cereals, watches and flu medication for manufacturers. "It used to be only luxury products were diverted, but it's spreading into all areas: shoe polish, baby formula, circuit boards, individual bags of sweetener," he said. "If it can be diverted, they will find a way." In recent years, the Internet has provided an expanding forum connecting gray market buyers and sellers, said Deloitte's Conroy, who is based in Indianapolis. For every battle won or lost, there's always another in the works. "It's like a game of Whac-a-Mole," Conroy said. "You knock one down and another pops up." The recession also may create a "huge explosion" of trading on the gray market, said Vaughn Volpi, vice chairman of Professional Investigating & Consulting Agency Inc. Consumers will be looking for cheaper products, and unemployment in China may lead more people to turn to the gray market for work, he said. In some cases, manufacturers are succeeding in stopping the distributors. P&G, the maker of Duracell batteries and Hugo Boss fragrances, uses former FBI agents and regulatory, legal and fraud experts to track and halt product diversion, said Kevin Otero, general manager for the company's North America Professional Care division in Woodland Hills, California. Kimberly-Clark Corp., the maker of Huggies diapers and Kleenex, has "a strong product-diversion prevention program," said Joey Mooring, a spokesman for the Dallas-based company. He declined to provide details. Clorox Co. asks its distributors to sign contracts ensuring that goods arrive only at their designated destinations. "We work very hard to monitor it," said Kim Rivera, a lawyer for Clorox in Oakland, California. "If we do find proof of diversion, that is the end of that business relationship." Product diversion isn't a "big problem" for Clorox, she said. The company gets 20% of sales from overseas. One way P&G, the world's largest consumer-products maker, is fighting back is by developing algorithms to assess order patterns. If a buyer exceeds the amount expected, the Cincinnati-based company may flag the distributor for scrutiny and cut the order, P&G's Otero said. Steps like these have helped P&G staunch distribution of the most recent Sebastian salon products to unauthorized outlets such as supermarkets and drugstores, he said. The new line, introduced last July, includes Whipped Creme mousse and Trilliant to protect hair against heat and add shine. "Any Sebastian Professional product you see in a CVS or Walgreen would be gray market," Otero said. Both CVS Caremark Corp. and Walgreen Co. carry Sebastian hair-care products and confirmed they buy products from third-party distributors. When P&G acquired Sebastian in 2004, the product line had a 3% share of the retail hair-care market because of diversion, he said. P&G has since dropped more than 150 buyers, and now has less than 1% of the market, as measured by Nielsen Co., Otero said. Of 10 professional hair-care brands tracked, there was a decline only in the diversion of Sebastian products in 2008, according to the Beauty Industry Fund, a trade group. CVS, the largest US drugstore chain, buys all of its hair-care products though legitimate channels, spokesman Michael DeAngelis said. Walgreen, the second-biggest, "requires a lot of documentation that the product is authentic and bought legally," spokeswoman Tiffani Bruce Washington said. Both chains declined to identify suppliers. (Bloomberg)