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A hairy problem for salons

The diversion of salon-only hair care products into what the industry calls the "gray market" costs manufacturers and salons millions of dollars per year in lost sales, diminished brand value and legal fees.
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My friend Lisa asked me to find out why drugstores, supermarkets and discounters are able to sell high-end hair care products that say "For Sale in Professional Salons Only."

It sounded like a simple enough question, but it turns out to have a complicated answer.

"You've put your finger on the most controversial and contentious issue in the industry," said Mary Atherton, editor of Modern Salon magazine.

It turns out that products made by manufacturers such as Paul Mitchell, Redken, Sebastian, Tigi and many others are not supposed to be sold anywhere but in salons. If they are, then somewhere along the line a distributor or salon has broken an agreement with the gel or mousse maker.

But selling these products through alternative channels is not illegal, even if it violates a manufacturer's contract. So it's up to the manufacturer to catch the wholesalers, distributors and salons that are selling products on the side, and that's not always easy. The result is rampant "diversion" of hair care products into what the industry calls the "gray market."

The phenomenon costs manufacturers and salons millions of dollars per year in lost sales, diminished brand value and legal fees. But strong consumer demand for these products and retailers' ability to buy them keep the practice going. Company executives estimate that 15 percent of all salon-style hair care products end up being sold through unapproved retail channels.

"We have done a good job of creating a product, creating a brand name and creating satisfied customers," said Luke Jacobellis, chief operating officer for John Paul Mitchell Systems of Beverly Hills, Calif. "But if the drugstores of the world and others know that, and there's demand for that product, then if they can get the product they'll put it on their shelves."

Though manufacturers of hair products and salon owners speak in unison about how troubling diversion is, some in the industry say the issue can be more complicated than a simple double-crossing wholesaler.

In a typical gray market situation, a wholesaler receives products from a manufacturer and sells them, on the sly, directly to retailers or to other distributors. There could be several steps between that wholesaler and the end consumer because the profit margins on hair care products can be quite high, so there is plenty of room for middlemen to divvy that margin up, each taking a small cut.

"They can buy it at wholesale, turn it over to a wholesaler to sell to another wholesaler and everybody can get something," said Jacobellis. "And the retail industry, they're known to work on small margins anyway."

That's one reason Jacobellis can't just call up Wal-Mart and ask the company where its Paul Mitchell Hair Thickening Spray came from. Wal-Mart may not know.

Some industry insiders say manufacturers aren't totally free from blame -- in part because they put so much pressure on distributors to sell, and in part because they turn a blind eye when diversion yields big revenue gains.

"The manufacturer will set quotas for the distributor, and the quotas are totally unrealistic. They'll say, 'If you don't buy a million dollars this quarter, I'm going to go to another distributor,' " said Paul D. Finkelstein, president of Regis Corp., which owns 10,000 salons, including Supercuts, Vidal Sassoon and Trade Secret. "So [the distributor] buys a million dollars and sells a third of it to Rite Aid."

Some manufacturers become addicted to the added sales in alternative channels and look the other way when distributors sell to the gray market, Finkelstein said. "They could stop it tomorrow if they really wanted to."

The third structure of diversion seems the most unsavory: A salon deliberately orders far more of a hair care line than it needs and resells the extra items to a "collector," who amasses bottles, pumps and sprays from salons in a region and then sells them to retailers or distributors. A small minority of salons participate in this kind of activity, but it still amounts to millions of dollars a year.

"It's very scummy," Atherton said. "Some of the people who are involved [as collectors] are the same as the wiseguys that are out in the streets dealing with other illegal stuff like counterfeit prescription drugs and counterfeit baby formula."

Indeed, counterfeiting is another issue that makes the gray market worrisome to manufacturers. Industry officials warn that diverted bottles may contain fake products that might not be clean or safe.

"We're in court right now finishing up a case in Florida where a fair amount of counterfeit was brought into the country," said Jacobellis of John Paul Mitchell. "The problem is the retailer doesn't always know where their product came from. If it's in a salon, at least it came through our distribution channel."

Some manufacturers, like John Paul Mitchell, actively campaign against diversion with court fights, investigations, ad campaigns and direct communication with salons. But it's salons that have the most to lose, because when someone buys a product in a drugstore, the manufacturer still made the sale, but somewhere, a salon lost one. And much of a salon's profit comes from selling hair care products.

That's the theory behind a product line called Profound that will be rolled out nationally in April. Company cofounders Nikos Mouyiaris, an entrepreneur, and Bob Salem, formerly with L'Oreal, set out to thwart diversion in three ways. First, Profound's products are hard to understand without the guidance of a stylist. For example, the shampoo is deliberately not designated for "dry hair" or "color-treated hair," it is described only as 90/10 or 60/40, for example, which refers to the ratio of cleansers to conditioners.

Second, each bottle of Profound has the name of the salon selling the item incorporated into the logo on the bottle. It's a customization process that Salem said took nearly three years to develop and will prevent anonymous salons from selling to collectors.

Finally, the Minneapolis-based company will award stock options to every salon that's a customer, giving the owner of that shop a vested interest in maintaining the brand's exclusivity. "You will never find the Profound product in a drugstore," Salem said. "It's one of the reasons we're getting such a huge response to Profound in our infancy."

That a whole product line could be launched based on assurances that it won't end up in the gray market is a sign of how damaging diversion is to stylists, whose profit margins are already eroding because of the soft economy and the growth of low-cost hair-styling chains.

But even if Profound is a success -- which will depend, of course, on how well the products work -- the diversion market for other brands isn't likely to go away, no matter how much industry hand-wringing goes on. Too much money is at stake.

Manufacturers, distributors and retailers profit from the gray market, as do consumers when they find their favorite brands at sometimes lower prices or in a more convenient location. No marketing campaign is more powerful than that.