Historically, dividend growth portfolios have performed the best out of all forms of equity investments. To test this against my own preferred, high yield portfolio, I decided to run an experiment and create 2 real world portfolios to track over several years. You can see both portfolios here and here). Among the dividend growth stocks that I researched was an exciting mid cap whose ability to generate controversy and investor profits is astounding.
Nu Skin Enterprises (NUS) is a multi-level marketing seller of over 200 anti-aging creme, treatments and nutritional supplements that has been one of the best stocks of the last 5 years and one of the strongest dividend growth stocks in the last decade. However, recent legal risks involving its business model in China have sent the stock crashing down by a third. Is this a rare buying opportunity or a warning sign for investors to stay away?
Nu Skin utilizes the multi-level marketing (MLM) business model made famous by Tupperware, Electrolux, Amway, Mary Kay, Avon Products, (AVP) and Herbalife (HLF). It is not sold in stores but is available for sale in 53 countries from one of about 950,000 independent distributors. Each distributor is required to buy a large amount of product, both for their own use and to try to sell and recruit other distributors. They receive a commission from people they recruit, on a decreasing scale, for several levels of new recruits. This pyramid like organization, with its many layers of residual commissions, creates a possibility for incredible income, which is the main selling point for people to join the organization.
Critics of the business model argue that MLM companies such as NU Skin are inherently faulty since only a small amount of top distributors make any meaningful income and most participants lose a great deal of money buying overpriced and useless products. This results in a large amount of personnel turnover. In Nu Skin's case, the Federal Trade Commission, (FTC) investigated the company in 1992, and the company settled with 5 states whose attorney generals had accused the firm of deceptive sales practices. In 1994, the FTC fined NU Skin $1 million for making unsubstantiated claims about its products. In 1997, the company was fined another $1.5 million for continued unsubstantiated marketing claims, mostly related to how much money individuals could make selling the company's products.
In 2012, a Seeking Alpha contributor Andrew Left, of Citron research, published a scathing article accusing Nu Skin of running a MLM operation in China, where such business models are illegal. He appeared vindicated when, on January 16, 2014, the People's Daily, a Chinese paper, announced a government investigation into Nu Skin's business practices. The news of the probe sent shares down 38% in 2 days and caused company CEO Truman Hunt to vociferously deny all the allegations. The selloff has either created an amazing buying opportunity for a misunderstood, but immensely profitable investment, or will signal a massive blow to future growth of the company's products in China, where 41% of the company's revenues are derived.
First let us address the question of whether or not Nu Skin is a legitimate business. MLM, though it may be controversial, is a legitimate business model, just a terrible one for distributors. According to the latest FTC investigation, only 11.7% of Nu Skin distributors earned a commission, which averaged $931/month. 88% didn't reach their quotas and most lost money. That is just the nature of MLM. The top 5-10% does well, the next 5% or so breakeven, the rest lose money. It might be a system stacked against sellers, but Avon has been doing it since the 1940's and few people question whether or not they are a legitimate company. What Nu Skin is marketing is cosmetics and nutritional supplements. Cosmetics alone, is an industry that in 2008 was worth $43 billion in the US.
Globally, by 2017 the cosmetic industry is expected to reach $265 billion. We are talking a massive marketing opportunity as the world's population grows, ages and hunts for a fountain of youth. Nu Skin is no different from Mary Kay, Avon or any other cosmetic company. They market a product with extraordinary claims to willing customers who believe the products make a difference. The customers, money and a chance for investor profits are all very, very real.
Since 1995 Nu Skin has grown revenues 656%, or 12% on a compound annual growth basis, (CAGR). In 2014 sales are projected to grow another 13% on top of nearly 50% growth in 2013. The basis of this growth is the business model, with its exponentially increasing number of sales associates. This is especially true in Asian countries like China, were a large and growing middle class is willing to pay top dollar for a chance to turn back the clock. Management has proclaimed a goal of tripling international sales to $10 billion by 2020, which CEO Hunt called "aspirational" yet "reachable" and continued strong Chinese growth is an essential part of that strategy.
Earnings have grown 878%, or 13.5% CAGR. However, in the last 5 years, thanks in part to strong growth in China, EPS growth exploded to 38% CAGR. Critics of Nu Skin might argue that sales and earnings prove nothing. After all, earnings are easily altered or fabricated. Cash flow on the other hand is not, especially cash flow returned to shareholders in the form of buybacks and dividends.
As can be seen above, NUS generates a growing river of free cash flow and has done so for a long time. The company has a stellar history of share buy backs and a consistently fast growing dividend.
In fact, since instituting the dividend in 2001, Nu Skin has achieved 13 consecutive years of growing dividends, 15% CAGR over 13 years. In the last 5 years the dividend growth has accelerated, to 22% CAGR and in the last year the company raised its dividend by a stunning 50%. Yet after all this the payout ratio is just 22%, indicating that management can continue to keep growing the dividend for many years to come and a blistering pace.
Dividends, (which must be paid out of real cash flows) aren't the only proof that Nu Skin is a legitimate cash generating machine.
We can see that the company, with heavy insider ownership, (the founder Blake Roney, is on the board and owns 13% of the company) enjoys rewarding shareholders, including in the form of buybacks. Since 1998 the share count has declined an average of 2.13% annually.
In the last 5 years alone Nu Skin has spent $467 million on buybacks and $238 million in dividends, a total of $705 million returned to shareholders. This is out of 5 year revenue of $10.779 billion. So in the last 5 years 6.54% of all revenues Nu Skin generated were paid back to owners.
Looking at financial metrics, we see not only that management is effective in executing the company's growth model, but also very good at maximizing shareholder wealth, as its 46% return on shareholder equity, illustrates.
|Profit Margin (TTM):||10.87%|
|Operating Margin :||16.53%|
|Return on Assets :||20.26%|
|Return on Equity :||46.23%|
That is not to say that Nu Skin isn't without risks. Potential investors should know about what is happening in China, Nu Skin's biggest and fastest growing market. For 11 years, Nu Skin has been operating within mainland China using a direct seller model. This means selling their products out of stores as the law requires. The allegations against the company, included charges that the company's direct marketing methods were "akin to brainwashing," and that it has been boosting its sales through an illegal MLM organization, has drawn the attention of China's State Ministry of Industry and Commerce, who will investigate the charges. In response, company CEO Truman Hunt announced an internal company review of Chinese sales practices and a temporary moratorium on new Chinese sales associate recruitment. On January 21 He released a statement saying, "As part of our initial review, we were disappointed to learn that during our recent rapid growth, there were instances where some of our sales people failed to adequately follow and enforce our policies and regulations," However, he was quick to add that this was "not representative of our business in China." Though he did offer an apology to shareholders "We sincerely apologize for these unfortunate and unauthorized activities."
Analysts who cover the company seem unfazed, at least thus far, by the allegations. Olivia Tang, analyst for Bank of America has stated that there is no evidence provided by the Chinese paper and Timothy Ramey, an analyst at D. A. Davidson, has stated that in his opinion, the allegations are "preposterous," however "Will it have an impact on their growth rate in China? Probably," he says. "Will it derail growth? Will the company shrink? I doubt it."
Nu Skin bulls tentatively received good news on January 30, when the Chinese Ministry of Commerce granted Nu Skin permission to continue its 2014 expo in Shanghai.
There remains a sense of uncertainty and doubt as to the final fate of Nu Skin in China. Most analysts, such as Mr. Ramey, agree that the company will likely face stricter scrutiny and that the growth rate of sales in China may be slowed somewhat. However, it seems, at least for now, with the Chinese government allowing Nu Skin to continue operating without interference that a worst case scenario where the company is outright banned from the nation seems unlikely. This seems to indicate that Nu Skin is incredibly underpriced as I'll now demonstrate.
|Trailing P/E (ttm, intraday):||16.38|
|Forward P/E (fye Dec 31, 2014)1:||11.69|
|PEG Ratio (5 yr expected)1:||0.62|
As seen above, Nu Skin is trading at reasonable levels for such a fast growing company. This is due to the recent sell off on the news of the Chinese investigation.
However, by using a discount cash flow model we see just how undervalued Nu Skin is. By applying the expected 21% EPS growth rate for the next 5 years to the current EPS of $4.89, the company's 18 year historic growth rate of 13.5% for the next 10 years after that, and discounting by 9%, (the CAGR of the S&P500 from 1871 through 2013) we get a present day value of $270.13, representing a 70% discount, or margin of safety.
Nu Skin shorts would argue however, that the accelerated EPS growth that analysts were expecting now must be adjusted downwards to account for decreased growth out of China. This is true, and our model must account for it. However, the trouble is determining how much of a slowdown in China will this investigation cause? If we assume that the growth rate of global sales are proportional to the % of sales coming out of China, then we can assume 41% of global growth is due to China. As a method of being conservative we model that half of the Chinese growth will be lost due to changes in sales practices that will result from the investigation. In that case we can model the decrease in the 5 year EPS growth projection by about 4%, or 20% of the original estimate. In that case, if we also cut the long term growth rate down proportionally, we find 11% as opposed to 13.5% long term growth. Running this scenario through a DCF model gives us a fair present value of $183.76, and means the stock trades at a 55% margin of safety. This indicates that Nu Skin, even under a very conservative, near worst case scenario, still has 124% upside from its current price.
However, I would argue that with a dividend growth stock such as Nu Skin, only half of the valuation is based on earnings growth. The other half is based on the growing dividend. With a payout ratio of 22%, I think that management will be able to continue growing the dividend at the historical rate, even with future growth slowed due to the Chinese legal risk. So modeling continued growth of Nu Skin's of 15% annually, (its CAGR over the last 13 years), we model a 2018 dividend of $2.68/share.
Over the last 5 years Nu Skin's average yield has been 0.76%. If we assume that the Chinese investigation fears prove overblown, then in 5 years the yield is likely to have returned reasonably close to this historical level. In that case the price would be $352.07, representing a 330% increase from today's levels. Add in the $9.33/share in dividends one should expect over the next 5 years and you get a total value (shares+dividends) of $361.39. This represents a 35.1% CAGR over the next 5 years that grows to a 5 year total CAGR of 36.13% if one includes dividend reinvestment.
In conclusion, I concede that many might find Nu Skin's MLM business model of marketing its cosmetics and nutritional supplements, controversial, and there is very real legal risk in the company's business practices in China. That is Nu Skin's largest and fastest growing market and in the event of a catastrophic ruling against the company, its growth prospects would be greatly curtailed. However, even if Chinese growth is cut in half, there is still greater than 100% upside at today's prices and in the long term the growing dividend should still provide investors with truly incredible total returns.
In the summary, I feel the Nu Skin, at the current price offers an incredible opportunity for brave investors who have a long time horizon and a strong enough stomach to ride out market vacillations such as we've recently experienced. As part of a diversified, Dividend Growth portfolio, Nu Skin represents a fantastic market smashing return that can provide an exceptional kick to one's overall total returns.