1 Consumer Good to Sell, 1 to Hold, 1 to Buy
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Direct selling businesses offer some of the most attractive exposure to high growth. This is because of the nature of the supply chain model: distributors are incentivized to drive ever higher sales. At the same time, many tend to associate this kind of marketing with pyramid schemes. In the end, there are undervalued direct sellers and recklessly managed direct sellers. Below, I review a few with different risk/reward profiles.
Herbalife: A Clear Buy
This multi-level marketing company has received so much bad press of late that it is hard to present the other side to the argument. Ever since legendary short-seller David Einhorn implicitly questioned whether or not Herbalife (NYSE: HLF) was a Ponzi scheme during its earnings call, the stock has fallen significantly from its high. Shareholder value has recovered slightly from the local low, but there is still a lot more room for recovery.
Herbalife is, after all, a top quality name that has dramatically grown free cash flow over the years. The company also generated $431 million in FCF for the trailing twelve months. A year ago that figure was just $381 million. In my discounted cash flow model, I find that the fair value of the stock is $67.22.
My calculation is derived from holding per-annum revenue growth constant at 14.5% over the next five years and 2.5% into perpetuity. I assume a 23% tax rate and put capex at 2.6% of revenue. Cost of goods sold (COGS) is set equal to 20% of revenue, SG&A at 65%, and depreciation/amortization of 2.3%. We then need to subtract net increases in working capital, which is set equal to 0.2% of revenue.
Discounting backwards by 10% yields a present value of $67.22. It would take a bearish 1% perpetuity growth rate and a 12% discount rate to justify even a $47 per share valuation. The combination of strong growth and an undervaluation merits a large investment.
Hold Estée Lauder & Sell Avon
While Avon (NYSE: AVP) and Estée Lauder (NYSE: EL) both operate in a niche consumer goods market like Herbalife, they do not have the free cash flow necessary to justify their own valuations. Avon’s corporate management is entrenched, with Chairman Jung refusing to step down after years of leading the company through underperformance. In my view, it would be an ideal activist target if not for its already expensive stock price.
Going forward, Avon needs to focus on growth to encourage investors to come back. Unfortunately, FX headwinds may hold back some value creation, and years of cost cutting have been unsuccessful. Share losses, combined with weakened overhead margin leverage, have sent the company in a tailspin into take-over territory. After previously succeeding so much in international markets, it is a mystery why Avon isn't doing the same now. At 28x past earnings, however, the company is way too expensive to justify making an investment in, considering that EPS is expected to be flat over the next 5 years. I recommend selling.
Estée Lauder, on the other hand, is much more attractive in the beauty space but still not worthy of a buy. It is forecasted for 13.9% annual EPS growth over the next 5 years. Assuming that expectations are met, the stock would be worth $69.44 at a 16x multiple. Discounting backwards by 10% yields a present value of $43.12.
With the stock currently trades at $61.57, the market is currently exaggerating growth by a factor of 2.1x. Given that the multiple is around Avon's, it should be of no surprise that I recommend selling the competitor. Whereas Estée Lauder has been admittedly terrific and grown EPS annually by 14.9% over the past 5 years, Avon's growth rate has only been 2.4%.
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