During my 20+ years as an analyst covering branded consumer products companies, I have had the opportunity to witness the direct selling business model close up. I have published or co-published sell-side equity research on Amway, Avon, Blyth (PartyLite), Herbalife, Mannatech, Natural Health Trends, Nu Skin, Reliv, Tupperware (including BeautiControl and Fuller de Mexico) and USANA, and have also had the opportunity to interact with the management teams of AdvoCare, Natura, Nature’s Sunshine, Oriflame and XANGO. Jafra was part of Gillette when I co-followed that company prior to it being acquired by Procter & Gamble, and Princess House was part of Colgate-Palmolive from 1974 to 1994.
I buy my suits from Tom James, a Nashville-based direct seller of business apparel, which was founded by the same individual who is the current majority owner of Southwestern—a direct seller of religious books established in Nashville at the time of the Civil War when that city was still in the Southwestern part of the country (the city hasn’t moved, the country has). Berkshire Hathaway owns direct sellers including Pampered Chef and World Book, and the current Citigroup evolved out of financial services direct seller, Primerica. The direct selling business model has been thoroughly ingrained in our business culture for well over a century and has been very successful in engendering iconic global consumer brands such as Avon, Mary Kay and Tupperware.
So what is the controversy? Why are Herbalife, Nu Skin and other direct sellers continuously under attack in the financial press lately? I think it is because of short sellers capitalizing on a general lack of understanding of the business model in the investment community, which makes markets susceptible to being easily spooked by dramatic, inflammatory rhetoric without giving any regard to its substance. Layer that on top of the current overall nervous capital market conditions and that the bias is to sell the stocks on any rumblings of negativity regardless of the source and ask questions later. To the astute investor who understands the model, these periods of panic selling have often proved to be prescient entry points for those who take the time to develop a fundamental understanding of the companies.
Direct selling, which is a type of distribution system, has always involved two components: 1) the products that are sold directly to consumers via an independent salesforce, and 2) the money the salesforce makes as a commission on the product sales. I like to think of it as a continuum where at one end of the scale is the product and the other end is the income opportunity; each company has some component of both, it’s just a matter of the degree to which each component is emphasized.
Over the years, that continuum has been moving away from product focus and more towards income focus, driven primarily by the advent of the multi-level marketing compensation system pioneered with the founding of Amway in 1959. Amway is now the world’s second-largest direct selling company, and soon could overtake Avon as No. 1. Each of the company’s two founders, prior to the death of Jay Van Andel in 2004, was perennially in the upper quartile of the Forbes 400 richest Americans list.
With Amway’s success came others wanting to replicate the model: Herbalife was founded in 1980 and Nu Skin was founded in 1984, and both are now multi-billion dollar global, publicly traded direct sellers also employing the multi-level compensation structure. Even the more traditional direct sellers like Avon and Tupperware have moved their compensation systems to be more multi-tiered to enhance recruiting incentives.
A multi-level compensation plan typically pays out 40 percent or more of their wholesale sales as commissions to their independent distributor sales leaders, most of which is a percentage of the product sales made by other distributors the leaders have brought into the system, typically referred to as “downlines”. The number of distributor sales leaders who benefit from commissions on downline sales usually represents only 10 percent or less of the total distributor network. Put another way, typically 90 percent or more of the distributors in the network are not looking at their direct selling business as a full-time job, but are merely collecting commissions on their personal sales, or even just consuming the product at some reduced price and not selling at all.
In fact, according to the Direct Selling Association (DSA) website, the typical direct seller in the U.S. is a middle-aged woman with an above-average education working part time and grossing approximately $2,000 per year from her direct selling business.
The reasons she became a direct seller are twofold: 1) financial motivation, such as supplemental income for the family or perhaps income targeted for specific items such as the family vacation budget or a new appliance, and 2) non-financial factors, such as a) the opportunity for adult social interaction (i.e., the home parties), b) the recognition of success for her business achievements that accompanies all direct selling concepts and c) the fact that often times prior to raising a family many women were primary breadwinners with professional jobs and they miss that aspect of their lives. Full-time income is but one of many motivations to become a direct seller.
In my view, the reason the industry has migrated to the multi-level type of compensation plan is that recruiting, and retaining those recruits, is the key driver to growth. So, unlike traditional retailers where store productivity, as measured by same store sales, is the key metric that is usually analyzed, “new stores” (i.e., new distributor leaders) are the primary driver of growth for this business model. And the way new distributor leaders are produced is by sales leaders increasing their number of downlines.
Which brings us to the dreaded “pyramid scheme” label. A “pyramid scheme,” as defined by Merriam-Webster’s Dictionary is… “a usually illegal operation in which participants pay to join and profit mainly from payments made by subsequent participants.” In direct selling, the exchange of money and the commissions that are paid are solely based on product sales and consumption, not recruiting. So while the sales leaders benefit from recruiting others as the primary method to expand their businesses, the recruits have to generate real product sales and consumption in order for the sales leaders to get paid. This is not illegal.
Yet the model has been persistently under attack in the financial press, most notably with the recent bear raids on Herbalife and Nu Skin, two of the largest publicly traded direct selling companies. It’s hard to believe that with over a half-century of scrutiny of the direct selling business model by multiple branches of the federal government and 50 states attorneys general, coupled with scores of international regulatory authorities, there is some rock somewhere that hasn’t been uncovered that will fatally impugn the business model. Yes, Amway was once deemed a pyramid scheme in the UK, and Herbalife one in Belgium, but, tellingly, those sporadic findings have essentially been one-off events, and they have not slowed the global growth for either company, indicating perhaps that local politics could have been more of a driving factor than the discovery of any particular smoking gun.
Not to say there haven’t been some bad actors over the years, but they tend to be smaller companies that fly much more under the radar than the global giants. The issues that tend to get most of the bad actors of direct selling in trouble usually surround outrageous product claims or exorbitant income guarantees, or just outright fraud—like other business models we’ve seen lately.
I am very bullish on direct selling, particularly for these times. The model is nimble, typically asset light with large free cash flow, ideal for quickly penetrating under-developed emerging markets, and is definitely benefiting from advances in technology such as the Internet, and, more recently, social networking. Direct selling provides an income opportunity for many in societies who otherwise would be hard-pressed to find employment, particularly women, and in the developed world with its high unemployment rates, these concepts provide anyone with the drive to succeed the means to create a home-based business with very little up-front money. The model is essentially capitalism at its most basic.
So my message for those skeptical of investing in direct sellers is to hate the bad actors, don’t hate the business model.
Douglas Lane, named as The Wall Street Journal’s “Best on the Street” five times and a four-time Starmine Analyst Award winner, is currently a board member of 3000BC, a start-up Direct Selling skincare company.