Financial Analysis

China

Public direct sellers: China issues have direct selling stocks starting 2019 off slowly; rideshare unicorn IPOs banged up in the public markets.

China Issues Plague Direct Selling Stocks

Our proprietary index of Direct Selling stocks continues to lag the S&P 500 so far this year through mid-May, down 3 percent versus +13 percent for the market, which is fairly large underperformance. Since the market peaked in September of last year, our index is down 20 percent while the market has recovered most of its 2018 Q4 losses, and it is now only down 3 percent from last year’s highs.

Interestingly, the near-term earnings outlook for the S&P 500 hasn’t changed much since last fall, while our index on average is looking at earnings now that are +1 percent to +3 percent higher than they were at the end of last year. Therefore, the movement in the stocks is more due to lower multiples being applied to future earnings versus higher multiples being applied to the overall market earnings than before.

We think this change in perceptions is due primarily to recent events in China, where geopolitical events started to heat up at the end of last year, only to be exacerbated as this year progressed with the constant headlines about tariffs and trade wars. This impacted investor perception of the group, which is heavily exposed to China, particularly USANA Health Sciences (USNA; approximately 50 percent of 2018 sales were in China), Nu Skin Enterprises (NUS; 33 percent) and Herbalife Nutrition (HLF; 20 percent).

Then, beginning in January, the Chinese government commenced a 100-day review of the nutrition/wellness segment, which included a lot of direct selling companies.

This was accompanied by severely negative media coverage, adversely impacting the ability of the companies to recruit new members and sell to new customers. Then, the real underperformance for the group was in March, with our index declining 10 percent in a market that was up +2 percent. This fit right into the narrative behind the government crackdown in the space and focused directly on a component of our index.

By the time it came to report Q1 earnings, the bad news had come out. USANA, with its large China exposure coupled with the timing of the promotional calendar this year, warned in early April that it would miss expectations and it brought down its full year outlook. But the reduction was relatively modest due to accelerated marketing efforts expected for the rest of the year, including new product news at its Asia/Pacific convention in April. There, the company rolled out three new oral care products that are particularly adaptable to selling over social media. HLF largely met Q1 expectations, but momentum in China had slowed so much that it brought down expectations for the remainder of the year to give China the time to re-ramp, hopefully back to the double-digit sales growth rates that market was posting in 2018. NUS actually beat expectations in the Q1 and reiterated its full year expectations, noting that 70 percent of its business in China is personal care, which was not impacted by the government’s 100-day review.

Therefore, given events in China and soft early-year promotional program for USANA, coupled with the continued struggles at Avon and Tupperware, organic sales growth for our index decelerated in the Q1 for the second straight quarter.

However, despite its continued fundamental softness, Avon’s stock has doubled this year (through late-May) after disclosing that it has been in talks to be acquired by Brazil-based Natura, a deal that was officially announced at the end of May.

Additionally, OPTAVIA/Medifast showed decelerating trends in the Q1, which we actually viewed positively since it had been in the +100 percent range for the previous two quarters. In our experience that is a level where direct sellers tend to stretch their infrastructures and overheat, oftentimes resulting in sharp retrenchment. But, with Optavia’s strong growth in its health coaches, we think there is a good foundation behind the accelerated growth rates it has been posting recently. With international expansion on tap beginning this summer, Medifast remains the most compelling growth story in the group, in our view.

Lyft and Uber IPOS Start Out Under Water

The buzz so far this year in the public equity markets is over the initial public offering (IPO) of the rideshare unicorns, Lyft and Uber. As of mid-May, both were under water (below their respective IPO prices), with Uber trading under water ever since its first trade. Not an auspicious start for these highly anticipated offerings.

As someone following direct selling companies, we had a particular interest in the SEC registration filings for these two names in order to get a closer peek under the hood of what is behind their apparent successes. Given that we would view both of them as up there among the flagship names in the gig economy, we wondered how they grew so far so fast. Uber, at $50 billion in global gross bookings last year, is already larger than the total retail sales value of direct selling products sold in the U.S., all from a standing start in 2009.

Additionally, while the gig economy is vast, ranging from property sharers Airbnb & VRBO, online marketplaces like eBay & Etsy and on-demand service providers such as Task Rabbit and Door Dash, Uber and Lyft are the ones whose business model is predicated on supporting an independent contractor infrastructure, which in our view puts them closest to the direct selling business model.

The first thing that we noticed when the Lyft prospectus came out in March was that it was trying to support its independent contractor infrastructure with 42 percent gross margins, which seems untenable. Gross margins for the direct sellers we look at typically range from 60 percent to as much as 90 percent depending on the particular model. Avon, with gross margins in the upper 50 percent range, could be considered under margin duress, and, as it became very clear on its first quarter conference call, management is working hard there to reduce discounting and improve the product mix to get the economics back where they should be.

Therefore, in our view, 42 percent just isn’t in the ballpark. Further, given the intense price competition in the space, with the much-larger Uber, as well as many other private regional players, coupled with the very visible unrest among drivers at both Lyft and Uber over trimming payouts, it’s hard to see them getting to where they need to be to eventually become self-funding. Enjoy your investor-subsidized rides while you can.

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