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June 01, 2012

Canaccord Summary

June 2012 — Direct Selling’s Efficiency as a Business Method—An Analyst’s Perspective

by Scott Van Winkle, CFA

Click here to order the Direct Selling News issue in which this article appeared.

The direct selling channel enjoys many attributes that often allow it to be a superior method of retailing products and services. Some of the benefits are obvious for retailing, such as the use of parties and testimonials by dedicated distributors, or distribution where traditional retail distribution is limited. While it is often simple to see how direct selling can be more effective, its superior efficiency is often overlooked. This business model is one of the most efficient distribution models available to consumer product companies, both from the standpoint of capital investment and people infrastructure.

Figure 1: Financial Model Comparisons in Beauty and Skin Care
Source: Canaccord Genuity research and Capital IQ

Figure 2: Financial Model Comparisons in Nutrition
Source: Canaccord Genuity research and Capital IQ

Generally, a direct seller requires lower levels of fixed capital invested in retail stores and distribution infrastructure given that products are almost universally shipped by common carrier to consumers’ or distributors’ homes. The direct-to-consumer model inherently yields higher margins that are deployed into a commission structure that provides a business model for distributors. Additionally, the lack of an employed salesforce—given that distributors are generally independent contractors—leads to a more scalable platform that requires less investment in salary and benefits as the business grows. Finally, the centralized distribution and independent salesforce provide for more rapid and efficient international expansion. In the peer comparisons highlighted here, the average direct seller generates over 70 percent of sales internationally vs. the average traditional retailer generating less than 5 percent of sales internationally. Only the larger multinational brands generate a meaningful percentage of sales internationally. While many consumer companies will consider which selling method is effective first and foremost, the efficiency of the model can generate superior returns on investment. These higher returns on investment are increasingly becoming clear to investors. To illustrate, the following charts compare the gross margin, return on equity and capital expenditures as a percentage of sales of select direct sellers vs. traditional retailers/brands. Only data from publicly traded companies was compared to ensure integrity of the data, and the comparisons have been grouped into two sectors.

This business model is one of the most efficient distribution models available to consumer product companies.

First, we compare the metrics of direct sellers of beauty and skin care, Avon Products and Nu Skin Enterprises, against traditional beauty and skin care companies, Ulta Salon, Elizabeth Arden and Estee Lauder (see Figure 1). The comparisons are quite clear, with the direct sellers generating higher product margins (gross margin) and higher returns on equity (the most important characteristic), and requiring lower capital investment as a percentage of sales.

Second, we compare the metrics of direct sellers of nutrition products, Herbalife and USANA Health Sciences, against traditional retailers of nutrition products, GNC and Vitamin Shoppe (see Figure 2). The margin and return on equity disparities are quite significant, while the capital investments are more comparable, as GNC has limited store growth investment at its mature state, but the modest difference of 2.2 percent vs. 2.5 percent is still measurable.

Successful companies in the channel should generate a higher free cash flow yield given the limited need for fixed capital investment, the higher margin potential as well as what is generally a more attractive working capital model given centralized distribution. With centralized distribution, inventory should turn faster and thus working capital should be more efficient. The attractive financial model characteristics inherent in direct selling have attracted greater investor interest over the last decade. This is clear in the successful stock performance of several multibillion-dollar publicly traded companies. However, private equity investment has also been on the rise over the last decade, and it appears that interest is at an all-time high. Whether it is investment in the growth stage of private companies or leveraged buyouts of publicly traded direct sellers, the attractive financial model is the key differentiator. Given the efficiency and cash flow, these companies can tolerate a higher level of debt leverage, further providing more attractive equity returns for private equity investors.

As the industry continues to grow (over $30 billion annually in the United States and $132 billion annually worldwide), we expect broader investor interest could lead to higher market valuations and thus greater potential returns to investors.

Scott Van WinkleScott Van Winkle is a Managing Director of Equity Research at Canaccord Genuity, the global capital markets division of Canaccord Financial. Canaccord Genuity offers institutional and corporate clients idea-driven investment banking, research, sales and trading services from 16 offices worldwide. Van Winkle, based in Boston, has followed the direct selling channel since 1997.

Disclaimer: Canaccord Genuity has published research recommendations on Herbalife, Nu Skin Enterprises and USANA Health Sciences and makes a market in shares of Herbalife, Nu Skin Enterprises and USANA Health Sciences. Canaccord Genuity has provided non-investment banking securities-related services to Nu Skin Enterprises in the last 12 months. Past performance is not indicative of future results and these comments are not a recommendation to buy or sell the specific securities discussed.