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A gray streak for hair-care goods

A BusinessWeek investigation finds pricey products meant for salon-only use and sale are in drugstores everywhere. What's going on?

by Ann Therese Palmer, Chicago-based special correspondent for BusinessWeek with Jessi Hempel in New York, and BusinessWeek bureau reports

December 17, 2004

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A Rite Aid store in downtown Seattle has a wide selection of hair-care products from Nexxus, Redken, Sebastian, Paul Mitchell, and American Crew. In Lake Forest, Ill., a CVS store carries a similar variety. And at a Duane Reade in Manhattan, just as ample a supply can be found. That's what you would expect to find at the local drugstore, right? Trouble is, these products aren't supposed to be available in retail outlets. They're intended for sale only through salons.

A six-week investigation by BusinessWeek found a thriving gray market in professional grade hair-care products. In a spot check of retailers across the country -- including Target, CVS, Duane Reade, Rite Aid, Walgreen, Filene's, Publix, and Eckerd -- we found shelves stocked with salon-specific shampoos, conditioners, hair sprays, and gels.

We didn't hit every location, but 15 of 19 stores we visited in 12 cities and towns nationwide were selling these goods. In many cases, the store had well over 100 products -- all with labels that carry a variant of the same message: For salon sale only.

CONSUMER ED.  Companies that make salon-only products allege that retailers are selling goods that have been improperly diverted from their intended channel of distribution. Up to $800 million of the industry's $29 billion yearly product sales may be diverted or counterfeit, estimates Steve Sleeper, executive director of the Professional Beauty Assn. He says diverted and bogus goods are growing at nearly twice the industry's 3% annual rate.

It's an issue makers of hair-care products say they can no longer ignore. Paul Mitchell has launched a multimillion-dollar TV and print campaign warning customers to stick to salons if they want the real thing. "Instead of spending millions to advertise our product, we're spending that money educating consumers about the problem," says John Paul DeJoria, CEO of John Paul Mitchell Systems.

DeJoria won't say how much the $800 million company loses to the gray market, but a recent study by A.C. Nielsen Market Decisions for the Beauty Industry Fund, estimates that last year retailers sold $19.6 million of the Beverly Hills (Calif.)-based company's products, up from $14.2 million in 2002.

FAUX HUNT.  It's not just bricks-and-mortar stores that carry salon-only products. On the Web, the same items can be found at sites from eBay and Amazon.com to Rite Aid's drugstore.com.

Stopping the sale of gray market hair-care products is difficult. No laws prohibit retailers from obtaining and selling these products. And federal and state officials are unwilling to jump into what they see as simply a contractual dispute. "Protecting companies' marketing agreements is not what we do," says Lesley Fair, an Federal Trade Commission attorney.

When products are diverted, the manufacturers still get paid by their distributors. So what's the problem? Manufacturers argue that since retailers don't buy directly from them, they can't confirm if the products are the real thing or counterfeit. Retailers have no fail-proof method for ferreting out these faux products. Also, because diverters often obliterate the manufacturer codes on bottles, companies can't recall products if they become contaminated.

BRAND EROSION.  Manufacturers also complain that their customers suffer. They say their products have limited shelf lives, which have often passed by the time the bottles hit retailers. Some shampoos, for example, use cream as an ingredient and become rancid if they're sold past their expiration date.

Manufacturers claim as well that these products are more specialized: Consumers don't know if a product "is going to give them the results they want" without help from stylists, says American Crew President Tony Nemer.

These companies are even more concerned by the extent to which diversion erodes their brands. They build reputations through exclusivity, setting higher prices because their hair-care products are used and sold only by hair professionals. If salon shampoos can be bought alongside VO5 and Pantene, what sets them apart from their lower-priced rivals?

"ETHICAL ISSUE."  Retailers insist they're doing nothing wrong. They say they get real products through legitimate wholesalers. "These products are authentic, and each is readily available and purchased legally on the open market," says Walgreen's spokesperson Michael Polzin. CVS also says it obtains the products" in a lawful manner from reputable suppliers," as do Eckerd, Duane Reede, Rite Aid, and Target. Repeated calls to Filene's and Publix were not returned.

Retailers may be on solid legal ground, but their policies raise an ethical question. If the distribution restrictions are designed to ensure quality control and consumer safety, as manufacturers claim, then "we have a core ethical issue," says University of Notre Dame ethics professor Reverend Oliver Williams. Retailers can get the products legally, but since they can't guarantee the products came from the manufacturer, should they do so? Are they putting consumers at risk?

Most makers of hair-care products are small companies and are reluctant to take on big retailers -- especially without the law on their side. Paul Mitchell may be the most aggressive when it comes to fighting back. Micheline Re, a lawyer for the company, says she sent CVS a letter on Aug. 31 asking them to stop selling Paul Mitchell products. She says CVS has not responded.

ENTER THE COLLECTORS.  Re says she also sent letters to eBay, Walgreens, and Amazon. eBay and Amazon both say they function as marketplaces, not a retail outlets, and thus only facilitate sales. eBay has set up a program to help manufacturers reach the diverters who eBay to peddle products.

How does the gray market work? Aveda, Mitchell, and others have exclusive sales contracts with distributors and salons nationwide. Their products are delivered to local salons through a network of regional distributors, which also sign agreements with local beauty parlors prohibiting them from reselling the products.

Since retailers can't buy from manufacturers directly or their distributors, they typically get the products through wholesalers. The wholesalers often get their supply from individuals called collectors.

CUTTING SUPPLY.  "Collectors will come around in their vans and will offer [salon owners] about 20% over cost to purchase the product," says Erik Knutsen, Aveda's exclusive distributor in Illinois and Wisconsin. The collectors resell the products to wholesalers who then market them to drugstores and supermarkets. This year, Knutsen cut off supply to two salons that were selling to collectors.

When the salon sells to a collector, it may be violating its contract with the manufacturer and the distributor. Graham Webb CEO Rick Kornbluth says he has cut off hundreds of salons for violating their contracts this way. He estimates the fight to stop diversion has cost Graham Webb, which is owned by Procter & Gamble (PG ), $3 million in legal fees in the past two years.

Kornbluth says his products most often end up at wholesalers like Ronkonkomo (N.Y.)-based Quality King, which now does business as Professional's Choice. Arcenio Napiza, who manages an Eckerd store in Brooklyn, identified Professional's Choice as the supplier of their salon products.

QUIET SANCTION?  Other wholesale sources, according to Kornbluth, are Damien Christopher, which has locations in Irving, Tex., and Lutz, Fla., and San Diego-based Jade Beauty. Several calls to Professional's Choice, Damien Christopher, and Jade Beauty were not returned.

One way to cut the supply to wholesalers is to go after distributors and salons. But that hurts the top line. Wella, which makes the salon-only brand Sebastian, recently terminated an East Coast distributor, and cut off $3 million worth of business with salons in California and Texas, says Raymond Stapleton, a former FBI agent who heads Wella's efforts to fight the problem.

Despite such efforts, the products are so widely available through retailers that it's hard to believe some manufactures aren't quietly sanctioning the practice. One CEO of a company that makes beauty products exclusively for salons who didn't want his name used says his peers sometimes force distributors to buy more products than they can place, thus driving up sales. Then they look the other way when the distributor unloads excess products to wholesalers.

RFID-READY.  Consumers thinking they'll save a buck by bypassing salons in favor of drugstores should do their homework. Prices vary widely. The CVS store in Lake Forest, Ill., for example, sells a 33.8-ounce bottle of Aveda's Rosemary Mint Shampoo for $29. But at a nearby Aveda-owned store, the price tag was $25. The same shampoo is available online for as little as $23.75.

When diversion occurs, the biggest losers may be salons, which often depend on the exclusivity of these products for income. About 18% to 20% of the revenues at Chicago-based J. Gordon Designs come from Aveda product sales, says owner Jerry Gordon. He estimates that he loses 10% of Aveda sales to retailers.

What can be done to fix the problem? Manufacturers are introducing new forms of invisible codings to identify the original buyer, but smart diverters have figured out how to scrape the coding from packages or erase it using a black light, says Graham Webb President Kornbluth. He says RFID tags are a sure way to identify diverted products because they can't be removed, but they're too expensive to use widely now.

INTEGRITY COUNTS.  Meanwhile, the co-founders of Long Island City (N.Y.)-based startup Profound Beauty Inc. have devised a two-part method to keep their salon products out of retailer hands: They print the salon's name on every bottle, and rather than name the product, they number it. Only the stylist understands the number system.

Profound Beauty co-founder Bob Salem says the system costs more but protects the integrity of the hairstylist recommendation, adding, "That's not for sale in the mass market." And it keeps products in salons. Still, diversion remains an issue hair-care manufacturers may not be able to wash away any time soon.