Possible Inflection Point for Direct Selling Index; Recent Top-Line Deceleration Reversing.
One data point does not a trend make, but in a sharp reversal, our proprietary index of the publicly traded direct stocks has sharply outperformed the broader market as measured by the S&P 500 index through the first two months of the 2020 Q2. Through May 31, the quarter-to-date performance of our index is up a large +59.4 percent versus the +17.8 percent gain in the S&P 500 over that period.
To be sure, the index is coming off of record low valuations in March. From its recent peak in September 2018, our index had fallen (58.3 percent) through March 2020. While the earnings outlook for the group had declined (15.2 percent) over that time, the real driver to the dramatic stock under-performance was that the multiple that the stock market applied to those expected earnings dropped from 20.4x in September 2018 to 10.3x as of March 2020.
The COVID-19 outbreak has brought to bear two additional advantages for many of our direct sellers vis a vis the GIG players that are unique to the pandemic.
To put that in context, in the 20+ years that we have been tracking the group, it only traded at a lower multiple on expected earnings twice before. The first time was during the tech bubble in early 2000 when investors were selling anything that wasn’t technology, media or telecom (TMT) to chase those stocks, and the second time was during the Great Recession of late 2008 / early 2009 when the discount rate on stocks with large global exposures, which these companies tend to have, went through the roof. This time, it was the large exposure to China, as the media and regulatory environment soured for the group there in 2019, which then rolled into added uncertainties surrounding the coronavirus pandemic over the winter of 2019-2020 that drove valuations for the group back to the lower end of historical ranges.
Year-to-date, our Direct Selling index is down (1.9 percent), slightly outpacing the (5.8 percent) declines in the S&P 500 through the end of May. Interestingly, the P/E ratio for the group has merely returned to be close to 2019 year-end levels at 15.1x, while the P/E ratio for the S&P 500 has expanded to 22.1x from 18.3x despite the drop in the level of the index due to the sharply reduced outlook for market’s earnings expectations. So far this year, expected earnings for the S&P 500 have declined (21.8 percent), while for our index, they have only declined (2.1 percent). Therefore, given that the P/E ratio for our index is at a 31 percent discount to the market, very close to 10-year lows, at a time where relative earnings are holding up better, we could see stock outperformance being sustained and that we truly are at an inflection point.
COVID-19 Outbreak Fleshes Out Two Advantages for Many Direct Sellers vs The Gig Economy
Throughout our Battle for the Side Hustle series, we have been highlighting many of the similarities and differences between the direct selling business model and the models put forth by the recently emerging GIG players, which also offer microentrepreneurial platforms for individuals to earn income while providing workplace flexibility.
But the COVID-19 outbreak has brought to bear two additional advantages for many of our direct sellers vis a vis the GIG players that are unique to the pandemic: 1) its direct-to- consumer business model where products are shipped directly to the end customer without social interaction and 2) the fact that many of the larger direct sellers have nutritional product offerings, demand for which have only escalated with the global health care crisis. Below is some commentary from recent quarterly conference calls:
“…in a lot of countries, we’ve seen an increase in the immunity portion of our portfolio for those particular products as people start thinking about staying healthy…”
—Alex Amezquita – Herbalife Nutrition SVP Finance Strategy and IR
“…we definitely saw a pickup in some of these products that were designed to support immune function…”
—Doug Hekking – USANA CFO
“We also experienced stronger-than-anticipated demand for our nutrition supplements…”
—Ritch Wood – Nu Skin CEO
“…our business model, our route to market, our healthy product portfolio, our specific immunity products, and our direct sales to consumers and direct delivery to consumer homes couldn’t be more opportune.”
—Gregory Gould – New Age Beverages (Noni) CFO
To be sure, the greatest adverse impact from the global pandemic will likely come in the Q2; Herbalife Nutrition has already stated that its April Volume Points were down (1 percent), which is a deceleration from Q1 trends, although in our view it was very good performance under the circumstances. Additionally, there are added compliance issues as companies make sure that there are no unfounded claims being spread by distributors with regard to the pandemic; the FTC very quickly sent out warning letters to 10 Direct Sellers (none mentioned here) warning them of potentially improper product and business opportunity claims surrounding the coronavirus.
Meanwhile, the larger GIG Economy players have been hit hard by social distancing guidelines. Ride-share concepts Uber & Lyft announced large COVID-19 related layoffs in May, and the property-share concepts Airbnb and Vrbo have been decimated by cancellations and as customers also fume about refund policies. Conversely, after initial declines as its corporate lunch delivery business dried up with the move to work from home, GrubHub has seen a net tailwind from COVID-19 with restaurants moving to take-out service only and as consumers shelter in place. The impending shakeout in the foodservice industry remains a wildcard as restaurants begin to either re-open for in-house service or simply close permanently due to the financial stress of being closed for several months and then not being able to maximize their eat-in capacity.
Q1 Organic Sales Growth Shows Sequential Improvement, Reversing Recent Trends
That being said, we do expect a deceleration in Q2 results as the companies report their first full quarter under the new COVID-19 normal. However, we are inclined to look through that and focus on the resumption of improving growth trends in the 2020 second half, and we note that our earnings forecasts already assume very conservative assumptions for Q2 results. Since on balance estimates either stayed the same or went up following the Q1 reporting cycle, we believe that the market and our estimates are adequately conservative in Q2 expectations.
The key drivers behind our positive outlook for our Direct Selling Index in the 2020 2H are:
a) the landscape in China has reversed over the past year to now being quite favorable for the nutrition names there
b) the names in our index each offer wellness products, which should continue to be quite attractive during the current global health care crisis, and
c) the micro-entrepreneurial opportunity offered by these platforms should become increasingly attractive as we enter a global recession and potentially witness unprecedented unemployment rates
Therefore, we believe we could very well be in the early days of the next sustained period of outperformance for the group. DSN
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 firstname.lastname@example.org.