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Can Multi-Level Marketers Shake Off Short Sellers?

January 24th, 2013
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Investing Daily Article of the Week

by Ari Charney, Featured Expert, Investing Daily

It’s hard not to be utterly dismissive of multi-level marketing firms (MLM). After all, a passing mention of Amway tends to elicit involuntary eye-rolling, as it conjures up imagery of “get rich quick” seminars led by impossibly enthusiastic pitchmen. Then there’s the deep-seated cultural skepticism that all MLMs are simply pyramid schemes.

And if these negative connotations aren’t already enough, there’s the epic battle underway among hedge funds over whether the long-term trajectory of Herbalife’s (NYSE: HLF) share price is ultimately zero.

But I keep seeing shares of MLMs listed among the holdings of mutual funds that I respect. For instance, the top-performing mutual funds managed by small-cap value specialists Royce & Associates hold 12.6 percent of Nu-Skin Enterpises’ (NYSE: NUS) shares outstanding, and the fund family boosted its holdings in the MLM by 8.1 percent during the third quarter.

Follow up:

And when MLMs kept popping up among the results from stocks screens with criteria such as high insider ownership, substantial returns on invested capital, and returns on capital that exceed cost of capital by at least a two-to-one ratio, I finally decided it was time to dig deeper.

In particular, the two MLMs that caught my eye are the aforementioned Nu-Skin along with Usana Health Sciences (NYSE: USNA).

But before we proceed with discussing these two firms, it’s important to address concerns about MLMs possibly being pyramid schemes. The Federal Trade Commission (FTC), which regulates the direct-selling industry, distinguishes a legitimate MLM from an illegal pyramid schemed based on whether salespeople primarily earn income from sales of actual products to non-network customers.

In an illegal pyramid scheme, by contrast, the vast majority of income is derived from enrolling new distributors in the sales network.

Nu-Skin breaks out its selling expenses, which comprise commissions paid to its distributors, separately from its general and administrative expenses. For the third quarter, commissions as a percentage of total product sales were about 44.8 percent.

Usana classifies this compensation as associate incentives, and for its third quarter this expense represented 42.6 percent of total sales.

Both firms specialize in direct selling of nutritional and personal care products. And unlike a fly-by-night illegal pyramid scheme, Nu-Skin was founded in 1984, while Usana’s origins date back to 1992. Both companies went public in 1996.

The entire publicly traded MLM industry has sold off in sympathy with Herbalife. That means both firms are well off their 52-week highs. Usana shares have had a steadier performance than Nu-Skin over the past year, gaining 9.5 percent vs. Nu-Skin’s 5.9 percent loss. For context, Herbalife is down 21.8 percent over that same period.

But over the past five years, Nu-Skin’s stock has gained 25.9 percent annually, as compared to Usana’s 1.8 percent annualized loss. Herbalife is up 18.6 percent annually during that time.

Shares of Usana seems to offer the better bargain in terms of traditional valuation metrics such as price-to-earnings, price-to-book, and price to sales, but there are a couple of serious red flags.

Although almost 50 percent of Usana’s shares outstanding are held by insiders, they’ve sold 10.4 percent of their shares over the past six months. To be sure, much of that selling was concentrated toward the end of November, when the stock was trading around $42 to $43 per share, which is about 13 percent to 15 percent higher than where its shares trade presently. At least in the short term, management appears to have timed their selling well. But equally telling, they’ve yet to pick up shares now that they’ve fallen.

By contrast, Nu-Skin’s insiders hold almost 14 percent of shares outstanding, with a barely perceptible uptick in holdings over that same period. That suggests management sees further upside ahead.

But given Herbalife’s travails, short selling is definitely a major concern with MLMs right now. Thanks to hedge fund manager Bill Ackman’s savaging of the stock in mid-December, the percentage of Herbalife’s shares held short has jumped to 35.2 percent of its float.

Now that there’s blood in the water, Nu-Skin and Usana have suffered similar depredations. Because almost half of Usana’s outstanding shares are held by insiders, that limits the inventory of shares available to the public, making its float especially susceptible to short sellers. Indeed, a staggering 61.7 percent of Usana’s float is held short.

Meanwhile, 17.6 percent of Nu-Skin’s float is held short. That would be an alarming statistic for most companies, but it compares favorably to the level of short interest among its peers.

So investors should definitely steer clear of Usana, at least for now. But what about Nu-Skin? When short sellers dominate a company’s float, it can be extraordinarily difficult for stocks to head higher, even when the underlying business is fundamentally sound. Despite record growth, Nu-Skin’s shares are down 27.5 percent from its 52-week high.

However, Nu-Skin’s growth trajectory is certainly compelling. Over the past five years, sales have climbed 9.4 percent annually, while profits have grown 36.1 percent annually. And return on invested capital has averaged 20.6 percent during that time.

Wall Street analysts project sales growth of 9.5 percent over the next 12 months, and earnings growth of 13.3 percent. The company has beat analyst estimates for the past eight quarters, and management’s preview of fourth-quarter earnings shows it beat its prior revenue guidance by $58 million. So the shorts could be in for a rude awakening in future quarters.

Nu-Skin also has outsized exposure to fast-growing emerging markets, particularly Asia. Roughly 78.2 percent of its 2011 revenue was derived from its Asian operations. And Latin America offers another major growth opportunity, as MLMs have yet to make major inroads there. Instead, most direct selling is done through the single-level marketing model, where salespeople are paid solely on the basis of product sales.

As evidenced by its stake in the firm’s stock, management’s interest is firmly aligned with shareholders. My only quibble is that the company’s equity incentive program is tied to performance thresholds based on earnings per share. Since earnings can be manipulated, it’s preferable for a company to tie performance-based compensation to financial metrics that don’t lend themselves to chicanery.

Although Nu-Skin only recently transitioned to mid-cap status, it’s paid a quarterly dividend since 2001, and it’s raised its payout each year since then. In fact, the board approved a 50 percent hike in the dividend to $0.30 per quarter in 2013, which represents a 140 percent growth in payout over the past three years. Nu-Skin’s shares currently yield 1.8 percent.

In addition to its dividend, the company has a share repurchase program under which it bought back 4.1 million shares (about 7 percent of shares outstanding) for a weighted average price of $43.95 during the first nine months of 2012. That’s slightly below where the stock trades currently and nearly 7 percent below the mid-point of the stock’s 52-week trading range, which shows that management is not overpaying for shares. At the end of the third quarter, the company had $157.2 million remaining in its repurchase authorization.

Even with these attractive fundamentals and shareholder friendly practices, I still can’t quite shake my distaste for the MLM business model. Additionally, the fact that nutritional supplements are one of its main product lines shows that the company is hardly breaking new ground. The very first MLM began selling nutritional supplements back in the 1940s, and many firms in the industry still do so today.

Sure, Nu-Skin has a chief scientific officer with a Phd and lists a robust product pipeline of anti-aging supplements and skin treatments, along with a weight-management system. But it still feels like you’re investing less in the products themselves and more so in their sales system. The MLM space has plenty of entrenched competition utilizing similar approaches to sales, so it’s tough to know what aspect of the firm could give them an edge over the long term.

But aggressive investors who don’t share my squeamishness or mind hedge fund-induced volatility could pick up shares on the cheap the next time Bill Ackman inveighs against Herbalife.

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