Financial Analysis

Public Direct Sellers: Why We Have “Regulatory” and “China” as Risk Factors; Stocks Feeling the Pain

China deteriorates substantially, and it’s not geopolitics 

Business in China for the publicly traded Direct Selling stocks slowed substantially in the Q2 due to the government’s crackdown on direct selling nutrition companies earlier in the year. The most exposed of the five stocks in our index are USANA Health Sciences (USNA), with about 50 percent of its sales in China, Nu Skin Enterprises (NUS; 33 percent) and Herbalife Nutrition (HLF; 20 percent). Exposure for Tupperware (TUP) is a low-double-digit as a percentage of sales, but it was not affected by the government’s actions, and Medifast (MED), which owns OPTAVIA, has no sales exposure there as yet.

Although the Chinese government’s 100-day review period ended in April, it was much more difficult to re-accelerate growth over the summer than the companies expected given not only the limited ability to hold meetings during the review period but also due to the added damage to the image of the sector as a result of the accompanying media coverage, which had more of an adverse impact and is taking longer to repair than anticipated.

Each of our three nutrition companies exposed to China saw positive double-digit top line momentum coming out of 2018 turn to substantial double-digit declines by the Q2 of 2019.

  • For USNA, Greater China, which includes Hong Kong & Taiwan, saw local currency sales declines of 18 percent in the Q2, down from 3 percent in the Q1 after growing double digits in the previous five quarters.
  • Local currency sales for NUS in China declined 19 percent in the Q2 after growing +12 percent in the Q1 and +21 percent for all of 2018.
  • HLF was most impacted with local currency sales declining 30 percent in the Q2 after being down 25 percent in the Q1 and being up +11 percent for all of 2018.

In aggregate, we have reduced our 2019 full-year sales outlook in China for the three companies by about $700M, or 25 percent, since the Q4 reporting cycle. Talk about the regulatory environment being a risk in China!

So, what are the companies doing about China? Below are some snippets from Q2 earnings calls that should help provide insights into how managements are thinking of China heading into the 2019 back half.

Herbalife Nutrition:

“Let’s look at what we are doing to stimulate the Chinese market. First, we expanded our e-commerce platform late in the second quarter to give our China retail customers the ability to purchase products directly from the company. This is the first stage of a larger project where we are working in partnership with Tencent, whom you may know is a leading e-commerce and social media platform, to establish a social e-commerce channel in conjunction with our established business model. The full platform is expected to launch in the fourth quarter of this year.

Second, we have improved the economics for service providers with a focus on enhancing the profitability and activities of nutrition clubs. And third, we are executing on our China growth and impact investment program with exciting branding opportunities, including our official nutrition sponsorship of the International Champions Cup,” says Michael Johnson, Chairman & CEO.

Nu Skin Enterprises:

“On a more positive note, our customer base remains fairly steady benefiting from several consumer initiatives. Toward the end of the second quarter, we began holding limited meetings and the approval of sales meetings has continued to improve into July and now August.

“Despite this recent disruption, we continue to see great potential in China. It is a vast market with motivated, entrepreneurial people who need and appreciate both our products and opportunity.

Several key initiatives, including the launch of a new Galvanic Spa and new incentives for sales leader performance, will kick off this quarter and should help strengthen our Mainland business,” says Ritch Wood, Chief Executive Officer.

Usana Health Sciences:

“Notwithstanding the challenging conditions we have seen in China during 2019, we continue to have confidence in our long-term growth potential in China. It continues to be a huge opportunity for USANA. And although it may take several months to see consumer sentiment return, we are committed to pursuing long-term growth in this important market.

…In China, we will first offer both a product-focused promotion and a separate business incentive during the quarter. And second, introduce new products at our China National Meeting in Macau during the fourth quarter, where we will again offer product promotions,” says Kevin Guest, Chief Executive Officer.

There certainly doesn’t appear any hedging on the enthusiasm shown by the companies on the long-term prospects for the market. Adapting to regulatory pressures is all part of doing business there.

Direct Selling Stocks Continue To Lag

Our proprietary index of Direct Selling stocks continues to lag the S&P 500 so far this year through the end of August, down 21 percent versus +15 percent for the market, as its sharp underperformance was only exacerbated by a poor Q2 earnings season.

As the graph on page 29 illustrates, organic sales gains decelerated further in the Q2 for the third straight quarter since peaking in the 2018 Q3. This time, only OPTAVIA (MED) showed strong growth among the components of our index, continuing its outperformance since rebranding two years ago, and we believe it is no coincidence that OPTAVIA’s business, at least for now, is 100 percent in the U.S. Our more global names, particularly those with large exposure to China, showed sharp organic sales declines in the Q2, with the exception of HLF which managed to keep organic growth flat in the quarter, perhaps a testament to it being the most geographically diverse among the components of our index.

As a result of the decelerating sales trends, the expected forward 12-months earnings for our index is now 7 percent lower than where it was at the beginning of the year, led by a 25 percent reduction in USNA, which is not surprising since it is the most exposed to China with half its business there and a 20 percent reduction in the outlook for TUP’s earnings. However, with its multiple being virtually cut in half to a record low 3.5x forward earnings from an already below average 7.0x during that period, the market seems to be telling us that TUP’s earnings outlook is still too high despite the sharp reductions so far this year. Conversely, OPTAVIA (MED) is now discounting forward earnings a full +33 percent higher than at the beginning of the year as good performance continues there.

And while geopolitics may not be a factor in the fundamental performance of the companies, it certainly could be a factor in the severe multiple contractions the stocks have suffered so far this year. As of late August, our index was trading at 11.1x forward earnings, down sharply from nearly 15.9x at the beginning of the year, and it is now within a point of its 10-year lows of 10.3x forward earnings and just 3.3 points above where it was trading during the Great Recession. Meanwhile, the S&P 500 is trading at 16.4x forward earnings, 2 points higher than where it was at the beginning of the year. It seems the market is fearing the next Great Recession, at least for direct selling stocks, could be just around the corner. Either that or we could be looking back in a year or so at what was a uniquely opportunistic buying opportunity for the group.