Direct Selling Index Continues to Lag the Market; Top Line Deceleration Continues
Our Direct Selling index recovered a bit in the 2019 Q4 and ended up being down (23 percent) in 2019, which sharply trailed the strong +29 percent gains in the S&P 500 for the year.
We note that we have removed Avon (AVP) and Tupperware (TUP) from our index retroactive to December 2018, given recent company-specific issues at each company, which in our view were disproportionally skewing the index. Avon stock’s outsized appreciation in 2019 was primarily driven by its anticipated sale to Natura, which was ultimately announced in late May and closed in early January 2020. Meanwhile, sharp declines in sales and earnings for TUP over the past 2-3 years have taken its equity market capitalization from a recent peak of approaching $4 billion in the first half of 2017 down to $130 million in February. As of early March, Tupperware’s CEO search continues.
That leaves Herbalife (HLF), Medifast (MED), Nu Skin Enterprises (NUS) and USANA Health Sciences (USNA) as the remaining direct sellers with over $1 billion in equity market capitalization, which we have set as the minimum to qualify to be in the index. Three of the companies, HLF, NUS & USNA, are heavily invested in China, which undertook a regulatory review of direct selling nutrition companies in early 2019, which dampened sales force activity, the reverberations of which are still being felt today. Meanwhile MED, which is still entirely U.S. based, although it has opened in Hong Kong and Singapore in its first moves to expand into Asia, saw the recent rapid growth rates of its Optavia business from 2017 into early 2019 sharply decelerate in the second half of 2019, trends which are expected to carry into 2020.
Therefore, not surprisingly, the earnings outlook for our index began to decline over the summer of 2019, with our index ending up in December of 2019 discounting forward 12-months earnings per share (EPS) that were (6 percent) lower than in December 2018. Meanwhile, the market, as is usually the case, began anticipating the reduced earnings outlook earlier in the year. Starting in February, when the news of the Chinese government regulatory action became widely known, the prospective price/earnings (P/E) ratio for our index began to contract. So, after coming into 2019 with a P/E ratio of 19x, our index exited 2019 with a P/E ratio closer to 15x. You put a lower multiple on lower earnings, and that is a recipe for underperformance.
The wide outbreak of a contagion like Covid-19, where the primary preventative step is to limit social interaction, works counter to a business model like direct selling, which is almost by definition is dependent on social interaction to drive growth.
On the other hand, the stock market, as measured by the S&P 500 index, gained +29 percent in 2019. Interestingly, the earnings outlook for the S&P 500 was little changed over the year, ending the year just +2 percent higher than it started. However, the P/E ratio for the S&P 500 expanded from 14x at the beginning of the year to 18x at the end as investors chased risk assets in this falling interest rate environment. The yield on the 10-year Treasury note went from 2.7 percent at the beginning of the year to 1.9 percent by the end.
The Chinese government’s regulatory review, coupled with the accompanying adverse media environment, had a significant impact on HLF, NUS & USNA in 2019, companies which we believe combined account for a low-double digit percentage market share of that country’s $35.7 billion direct selling market. The three companies’ combined sales declined (22 percent) in 2019, taking over ó billion dollars in net sales out of that market, which likely translates into over half billion dollars in retail sales. Given how important the wellness category is to direct selling in China, the only question now is how much of a double-digit decline did the overall China direct selling market suffer in 2019.
For all three companies combined, China went from being 28 percent of total net sales in 2018 to 23 percent of total net sales in 2019, with HLF specifically going to 15 percent from 20 percent, NUS to 30 percent from 33 percent and USNA to 44 percent from 49 percent.
COVID-19 Outbreak, Sharp Sales Deceleration at OPTAVIA Portend More Pressures on our Index
Our research report recapping last year’s stock performance, which we released in early January, was titled, “Direct Sellers Happy to Put 2019 Behind Them,” with the thought that business was beginning to improve for our more global names.
Although organic sales in the Q4 continued to decelerate for the 5th straight quarter and actually turned negative on average for the five companies we track (please see Exhibit 1 above), there was some sequential improvement at HLF & USNA for the second straight quarter. Our Direct Selling stock index increased +11percent in the quarter, better than the +8.5 percent gain in the S&P 500. Currencies have stabilized, and we are actually looking to be quite benign in 2020.
But no. By mid-January, word of the Covid-19 coronavirus outbreak began to spread, and the more global direct selling stocks were almost immediately hit. In addition, the deceleration in momentum at MED that we began to see in the 2019 2H decelerated further when it gave its initial 2020 forecast in February. After doubling its business year over year in the 2018 2H, growth rates at Optavia saw approximately +70 percent growth in the 2019 1H go to +40 percent growth in the Q3 then +20 percent growth in the Q4, with its initial outlook for 2020 slowing further to the low- to mid-single digits. This drove MED stock down (24 percent) this year through February after declining (12 percent) during 2019 as the market digested the slowing trends there.
Our Direct Selling index overall declined (18 percent) in January and another (12 percent) in February to be down another (28 percent) so far in 2020, on top of the declines last year, driven by the fallout from the Covid-19 outbreak and the sharper than expected deceleration in growth at MED. Our Direct Selling index is now down (51 percent) from its most recent 2018 Q3 peak. Prospective earnings for the index are already (9 percent) lower than they were at the end of 2019, and estimates still most likely need to be adjusted further downward to account for the rapid spread of the coronavirus outside of China to Southeast Asia and Europe.
The wide outbreak of a contagion like Covid-19, where the primary preventative step is to limit social interaction, works counter to a business model like direct selling, which is almost by definition is dependent on social interaction to drive growth. We would guess that those companies who are: a) less global, b) depend more on social media to drive sales growth and c) benefit from high subscription rates to mitigate turnover will be best positioned to ride out the storm.
Douglas M. Lane, CFA, is a securities analyst with more than 20 years of experience covering companies that employ a direct to consumer business model. He leads a boutique equity research firm, Lane Research, focusing on those companies. Please visit www.laneres.com. He can be reached at [email protected] and followed on Twitter at @Resarch_Lane.
Disclosures: Financial Interests
Neither I, Douglas M. Lane, nor a member of my household, owns any security (ies) which is/are the subject of this research report. Neither I, nor a member of my household is an officer, director, or advisory board member of the issuer(s) or has another significant affiliation with the issuer(s) that is/are the subject of this research report. I do not know or have reason to know at the time of this publication of any other material conflict of interest.