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Downgrading Nu Skin's Dividend Safety Score to Borderline Safe on Business Model Risks

In most cases, a company's financials paint a fairly clear picture of its dividend safety profile. A high payout ratio, substantial debt, weak profitability, or cyclical earnings can each serve as a warning sign that a firm's payout may not be sustainable in the long term.

However, sometimes there is more to the story. A business could face a lawsuit that has potential to result in a material liability (e.g. Johnson & Johnson's talc and opioid cases). A pharma company could be set to lose patent protection for a drug that generates the bulk of its cash flow (e.g. AbbVie's Humira). A natural disaster could suddenly jeopardize a firm's financial health (e.g. Vale's dam burst).

You get the idea – material risks can exist beyond the current set of financials.

Our Dividend Safety Score system does its best to stay ahead of these issues. We use dozens of industry-specific templates to help stay conservative in areas of the market that are more prone to risks beyond the current financials. We also make use of forward-looking analyst estimates to identify companies with financial situations that could be set to change materially, and I monitor news on many stocks as part of my ongoing research process.

At first blush, Nu Skin (NUS) appears to have the makings of a very safe dividend. The company's payout ratio has remained at or below 50% for more than a decade, providing a healthy margin of safety.
Source: Simply Safe Dividends

Meanwhile, the firm's balance sheet looks great with minimal leverage used.
Source: Simply Safe Dividends

Management has also demonstrated a commitment to the dividend, having increased Nu Skin's payout each year since the company began paying dividends in 2001.
Source: Simply Safe Dividends

However, today we downgraded Nu Skin's Dividend Safety Score from Very Safe to Borderline Safe due to qualitative concerns about its business model, which we believe will persist indefinitely.

These aren't necessarily reasons to sell the stock if you own it, but you should understand and be comfortable with the reasons why Nu Skin's profile looks riskier than its financials imply.

Nu Skin distributes personal care and nutrition products. While this is a simple business, the company is no stranger to controversy due to Nu Skin's sales model.
Source: Nu Skin Investor Presentation

Specifically, Nu Skin is a multilevel marketing company. In most parts of the world, individuals sign up to be distributors for Nu Skin. They can be required to spend a certain amount of money each month buying the company's products at cost and receive a commission on everything they sell.

However, they are also incentivized to get other individuals to sell for Nu Skin since they receive a slice of the monthly sales generated by all of the individuals they enroll. In other words, oftentimes the best opportunity to make money is to recruit and sell to more reps rather than actual consumers.

This type of business model rubs a lot of people the wrong way, and some argue it's an illegal pyramid scheme since the vast majority of participants lose money.

Over the years Nu Skin has faced investigations by the Federal Trade Commissionand others around the world over deceptive advertising practices and overstating the amount of income its distributors make:

  • "Herbalife, Nu Skin Tanks on ‘Multi-Level Marketing’ Crackdown in China" – Barron's,August 2017
  • "Nu Skin Faces $540,000 in Fines from China Review" – Wall Street Journal, March 2014
  • "Nu Skin Falls as China Vows to Probe Pyramid Suspicions" – Bloomberg, January 2014
  • "Direct selling of beauty products may get ugly after Nu Skin scandal" – South China Morning Post, January 2014
  • "Nu Skin Drops on Short-Seller Report" – Wall Street Journal, August 2012

From a dividend safety perspective, the main issue is China. China was immaterial to Nu Skin's business back when it started making dividend payments in 2001, but today Mainland China accounts for 33% of the company's revenue.

Unlike America, which is the largest multilevel marketing country in the world, China does not allow multilevel marketing and tightly regulates direct selling.

China actually banned direct selling in 1998 after widespread fraud and cheating, according to the South China Morning Post. The ban was lifted in 2005, helping Nu Skin's business in China enjoy substantial growth.

Nu Skin embraces a different business model in China to comply with the government's regulations, but it's still a controversial area. Earlier this year the Chinese government embarked on a new effort to reign in shady practices in this industry.

Here's what Natural Health Trends (NHTC), a Nu Skin competitor, noted in its latest annual report:

"On January 8, 2019, the Chinese government announced a comprehensive 100-day campaign focusing on companies involved in the sale of food, equipment, daily necessities, small home electrical appliances and services that are claimed to promote health. 

The Chinese government ministries in charge of this campaign indicated that they are targeting illegal practices in the industry, particularly the manufacture and sale of counterfeit and substandard products, and false advertising and misleading claims as to the health benefits of products and services. 

It is understood that the campaign is specifically focused on the business practices of direct selling companies. During the campaign, we understand that the government will not issue any additional direct selling licenses, will cease issuing certifications of quality or other approvals of various healthcare products, and will review its regulatory oversight of the industry."

What if the Chinese government decides once again to abolish the direct sales model, or at least clamp down much harder on the companies involved?

With a third of its business in China, Nu Skin would be right in the crosshairs. The company hasn't done much to calm investors' fears. Last week Nu Skin pre-announced disappointing second-quarter results and lowered 2019 earnings guidance, sending its shares falling about 15% as management blamed China:

"We are adjusting our guidance for the year primarily due to a reduced revenue outlook in Mainland China following the government's 100-day campaign to review and inspect the health products and direct selling industries." – CEO Ritch Wood

To be clear, I'm not suggesting that Nu Skin is doing anything illegal in China. The company has tried to implement an business model that comply's with the governments regulations (see below). However, with over 1 million independent distributor customers and more than 60,000 "sales leaders" around the world operating with questionable incentives, it's hard to say what's happening behind the scenes:

"The government of Mainland China has adopted direct selling and anti-pyramiding regulations that impose significant restrictions and limitations on businesses in our industry. Most notably, the regulations prohibit multi-level compensation, which is the basis of how we compensate our sales force outside of Mainland China.

In Mainland China, we utilize sales employees to sell products through our retail stores and website; independent direct sellers, who can sell away from our stores where we have obtained direct selling licenses and can also sell through our service centers or our website; and independent marketers, who are licensed business owners authorized to sell our products at their own approved premises or through our stores and website." – Nu Skin 10-K

Nu Skin has survived many allegations and regulatory changes since its founding in 1984. However, any adverse rulings or legal actions could harm its business and potentially even jeopardize its dividend if direct selling laws or anti-pyramid laws become much more restrictive in China or elsewhere.

This seems like a low-probability, high-severity type of event, but it's enough to place the stock in our Borderline Safe bucket to stay conservative. I prefer to invest in businesses that have less regulatory risk, clearer value propositions with the products they sell, and more in their control as they seek to grow.

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