Summary

Nu Skin Enterprises (NUS) stock price is off 50% in the past 15 months, driven by revenue contraction in mainland China.  Stock currently trades at 13.2x, near ten year lows relative to the S&P500.  The business ex-China is a steady LSD grower from here, and margins are quite stable.  The primary driver of variant view and the stock price is the China business.  I believe China revenues are near a stable bottom here, with more likelihood of upside than downside surprise.  The combination of fundamentals and valuation skews the risk/reward in favor of a long position in NUS.

Business Description ex-China

NuSkin is a direct selling company offering premium price skin care and nutritional supplements.  Growth is driven by signing up sales leaders, who function as the exclusive distribution arm for the products.  Commission payout is in the low 40's % range, and like any MLM the profitable business opportunity is concentrated with a relatively small number of people.  NUS was founded in Utah in 1984 and went public in 1997. 

Product mix is ~60/40 skin care and nutritional supplements.  Nutritional supplements range from $25-$60 list price for a one month supply, marketed toward a wide variety of specific health concerns (e.g. energy, memory, bone health, etc.)  On the skin care side, various products list at prices ranging from $10-$60, but increasing emphasis is placed on skin care systems (razor/razor blade model) where a device ($300-400) is purchased for use with monthly renewals of gels and creams, with a monthly cost of $100-150. 

Consumers and distributors qualify for ~30% discounts off suggested retail if they sign up for monthly auto-ship of product (ADR).  About 60% of total sales are on this ADR subscription basis.  Unlike some other MLM models, there are just those two price points (i.e. you can't load up your monthly order to get a higher volume discount.) 

Gross margins run in the mid 70's%, and they're effectively over 80% if you adjust for the fact that distributors can mark up by 20-30% on non-ADR sales.  Some bears point out the 80%+ gross margins to argue that this is overpriced crap.  I'm not a great gauge of product desirability, as I'm not exactly the target audience.  But I figure the effective gross margins are roughly comparable to, say, Revlon…  If a consumer buys Revlon product for $100, Macy's passes ~$35 to Revlon, whose COGS are 40% of that.  So <$15 of the $100 paid by consumer is product COGS.  Fluctuations in the past few years are minimal after accounting for inventory charges  and FX impact. 

The cost structure is dominated by variable selling expenses, which are about 40% but can spike up into mid 40's during times of outsized revenue growth (bonuses and incentives to the sales force).  G&A is in the 25% range, and mainly fixed costs: wages and occupancy, plus small amounts of R&D (<1% of revenue).  When growth is very high (was near 50% in 2013 due to bubble-like conditions in China), the higher selling costs are offset by operating leverage on the G&A line.  EBIT margins are 12-13% with modest operating leverage, probably high teens incrementals and a little worse on the way down, mid 20's decrementals. 

The balance sheet is strong, with net debt an insignificant 0.1x EBITDA.  Working capital is a use of cash in 2019 and capex is temporarily ~30% above maintenance levels, but I expect those headwinds to free cash flow to diminish by 2020.

Is the business legit?

First, let's acknowledge that multilevel businesses are lightning rods that attract a cast of characters: in the business and also as investors long and short.   If you want to be long an MLM, you need clear evidence that A) it's not pyramid scheme-like in its structure, and B) that the products have some level of intrinsic value, ie, people with free will and lacking skewed incentives want to buy them at current prices. 

The general test for pyramid schemes is to see if revenue is generated by true product buyers or by people paying up to get in on a money making venture.  The FTC halted Vemma in the US in 2015; they required a high ($500) initial investment, directly rewarded sales to affiliates as opposed to end customers, and lacked any meaningful discount mechanism to encourage retail sales.  Ackman's Herbalife thesis was in part is that five different price levels all the way down to 50% of retail encourage essentially the same thing: people over-order so they can arbitrage the price differentials, which eventually ends badly because a ton of people have closets full of unused inventory.

There are a ton of details on any MLM compensation scheme, but to me NUS passes the test for a few clear incentive related reasons.  1) No comp given for signing up salespeople, just for retail sales, and about half the total comp going to the person who makes the sale, and 2) Only two price points, and you qualify for the lowest price if you sign up for auto-ship directly from corporate on some product.  3) The ratio of product purchasers ("actives") to those who get compensation ("sales leaders") is consistently in the mid-teens or better (16:1 in 2015).  This is a pretty clean structure as MLMs go.  It's still an MLM, so it relies to some degree on social/peer pressure to make sales.  But there aren't any incentives to game the system with inventory loading or flooding the network with non-performing recruits.

Another way to look at this: the numbers seem to show that the products hold up.  For example, their core nutritional product, named LifePak, was introduced in 1992.  They don't report product sales quarterly, but it does come up occasionally in the calls.  LifePak generated $150M in 2001, and by 2013 it was up to $300M with >80% sold on a subscription basis.  The few quarters they call it out in between show pretty consistent sales; once a product is up and running, it has a long tail with a base of loyal, repeat customers.

Revenue Inflection Points

Over a couple decades, NUS has grown topline organically by ~5%.  However, the path has been significantly choppy.  There are several notable top line inflection points:

1. In the mid 90's, NUS entered Japan, and enjoyed early stage MLM growth in a good market from them.  Japan was 2/3 of their revenues by 1998.  At that point NUS was selling to 1 of every 300 people in the country, and was ~2% of Japan's direct selling market.  That was likely saturation for them, and Japan revenue never exceeded that level.  
2. From 1998 to 2007, sales went up at LSD growth globally, with no outsized growth in any region. 
3. Around mid-2000s, South Korea experimented with what they called the Limited Time Offer (LTO).  The idea was to generate demand around new products by limiting availability and creating hype.  Like K-pop, a frenzy in Korea spread globally to a surprising degree, beginning in 2009.    This began to get rolled out globally in 2009, and the growth trajectory changed dramatically.  LTO revenue was 100M in 2011, 300M in 2012, and 550M in 2013.  Beyond direct LTO revenue, this initiative raised the number of sales leaders and non-LTO sales. 
4. Outsized growth occurred in Mainland China in 2013.  Revenue jumped from 250M to $1B in one year.  This was aided by a special incentive plan to grow to $1B in China revenue.  This was achieved much more quickly than expected, leading to problems.  In January 2014, the People's Daily paper accused NUS of being an illegal pyramid scheme.  This caused a reset to the business, with China revenue dropping by 22% and 6% the next two years.

The LTO model has been the biggest driver of revenue volatility.  Outside the LTOs and ex-China, the business is a pretty steady LSD grower. 

The company has indicated they will be moving away from the reliance on LTOs to drive outsize growth.  While they will continue to launch new product a couple times per year, the rollout will be more local than global.  In exchange for not having short term revenue spikes, they will have a more consistent and predictable business, ex-China. 

I think the 70% of the business ex-China can be underwritten to a LSD growth rate with stable margins.  I also believe while this is not a variant viewpoint, it does provide a stable base of value.  From there, the key is to build out a view on China.

China

Amway was the first to built a large business in China from the 1980's.  A weak regulatory environment led to problems: counterfeit/inferior product, fraudulent marketing claims, pyramid schemes which paid for recruiting instead of products sales, and numerous examples of salespeople who incurred large debt/losses attempting to set up a business.  China banned all forms of direct selling in April 1998.  In 2005, as part of their agreement with the WTO, they began to allow direct selling again, with heavy restrictions to guard against pyramid schemes and other past problems.  Since 2005, direct selling has seen significant growth in China, with a total market that is now larger than the US and the largest in the world.  However, this growth has come in fits and starts, with significant government crackdowns on the industry in 2014, 2017, and this year as the regulatory situation continues to mature.

Mainland China is the largest individual geography for NUS and will be ~30% of revenue in 2019.  The regulatory regime prohibits MLM commissions.  The business is highly regulated, marked by the need to secure multiple approvals at the provincial and state level.  Sellers must be native Chinese, and an examination is required for certification.  Product also must be manufactured in China.  The maximum payout to salesforce is 30% of direct sales, which means structurally mandated lower selling costs in China than in other geographies.  Sellers are not allowed to purchase and resell inventory at a profit. 

The traditional MLM model relies on people who sell product and build the business by recruiting other salespeople.   That second function of building the business can't be done directly (i.e. paying for recruits) without triggering laws against pyramid schemes in most jurisdictions globally.  MLM companies generally instead incentivize building of downlines, where people get paid an override commission on sales of product by people they recruit into the business; thus the building business is still explicitly linked to product sales.  This downline component is illegal in China, making the "build the business" function more difficult to implement. 

Nu Skin, like Amway and most large direct sellers in China, operates a "hybrid model" whereby they sell both through retail stores and licensed independent contractors.  Independents can take either of two forms: direct sellers, who are commission only, or marketers, who also receive a salary but are the biggest concern for the regulators.  Retail store employees also receive salary.  In all cases, the sellers are referred to as "Sales Leaders" and their total compensation is constrained by the 30% maximum payout. 

The key to the salary is that it gets reset quarterly, and is tied not just to individual productivity but also to the productivity of other reps that are trained/managed/supported by that Sales Leader.  Thus it is able to function as an incentive to build the business, not just to make further individual sales. 

This could certainly be seen as a regulatory risk, and is flagged as such in the risk section of their K.  However, this arrangement is widespread, and direct sellers can't function without some mechanism to encourage business building.    The degree to which the major direct sellers have been in multi-year close interaction with regulators gives some confidence that 1) the regulators clearly understand the economic model of the direct sellers, and 2) their concern is less about stopping any incentive for business building, but rather avoiding fraud and other "disturbances to normal economic order". 

NUS China sales productivity per leader has been fairly constant, so the important driver is just the number of sales leaders.  Below is the history:

The tremendous spike in 2013 was tied to the aforementioned special incentives, where for 2 quarters they more than doubled the size of the Sales Leaders.  Although this did drive the business temporarily above $1B in China sales, it was not a good decision either for business or for the stock price.  While they got initial positive signals from the regulators for aggressive growth, that growth proved impossible to manage.  Sales leaders were making untenable claims about both product and the earning opportunity. 

NUS "voluntarily" agreed to suspend meetings and rebuild their base in a more sustainable way.  Taking out the 2 quarters of inflated Sales Leader numbers, the number of sales leaders dropped by ~8,000 before they were able to restore normal operations and a growth trajectory.

The 2017 and 2019 regulatory crackdowns were less directly tied to NUS.  In 2017, the company Shan Xin Hui ("Kindhearted Exchange") was the trigger: the company a Ponzi scheme promising returns on "investment" of 10-30%, paid for by new "donations" to the company.  In 2019, the trigger was the company Quanjian, a company selling herbal supplements and magnets: at its peak Quanjian did $2.8B in revenue, before outrage about negative medical outcomes reached a crescendo.  (A 4 year girl died after her father stopped medical treatment in favor of $750 of Quanjian product, which included essential oils and unspecified powders touted as a cancer cure.)  In both cases, regulators imposed a "cool-down" period with promotional meetings and new licenses suspended and companies asked to "self-examine" their production, marketing, and management processes.  In 2019, further steps include development of a black-list of suspect/guilty companies and an enhanced spot-check of marketing claims.    In both 2017 and 2019, NUS saw a decline of ~8,000 Sales leaders, analogous to 2014. 

The 2019 crackdown was supposed to last for 100 days, beginning in February.  NUS and others reported that the meeting restrictions lasted into the summer and then started being approved a somewhat slower than expected rate, in part due to government focus on the 70th Anniversary celebration preparation.  3Q numbers show stabilization with a sequential decline of ~2%; at the same time they report that provinces where meetings are being approved stepped up from ~60% in September to ~75% in November. 

Valuation

Consensus EPS for 2020 is $3.34.  The Street has China revenue down ~1% and the rest of the world flat. 

Downside: If China stays at 2H19 troughs through all of 2020, that's ~$55mm less revenue and ~$.25 less EPS.  $3 in earnings on flat growth could see a stock ~10% down from here.

Upside: China returns to growth in sales leaders, with their 2020 numbers equaling their 2018 average.  That adds ~$170mm in revenue and ~$.65 in EPS.  $4 in growing earnings should re-rate to at least 15x, meaning ~50% upside from here.