Shares of multi-level marketing firms Herbalife (NYSE:HLF) and Usana (NYSE:USNA) have bounced back in recent sessions, following their Nu Skin (NYSE:NUS)-induced sell-off. All three firms have received widespread support from sell-side analysts, who have defended the companies in the wake of renewed pyramid scheme allegations. Last week, the Chinese government began a probe of Nu Skin following an article in the People's Daily that alleged, among other things, that Nu Skin distributors were the victims of brainwashing.
The Chinese market is vitally important to all three firms -- both in terms of current sales and future growth. Given the Chinese government's long-standing hostility to multi-level marketing, investors shouldn't take China's probe of Nu Skin lightly.
Why China matters
As a percentage of sales, Nu Skin, Usana, and Herbalife have varying degrees of Chinese exposure. Nu Skin has the most, with about half of the company's revenue coming from China. Usana is second, with about 40%, and Herbalife has the least, near 11%.
Analysts at Canaccord Genuity defended Herbalife on that basis last week, noting that perhaps just 5% of Herbalife's total profit comes from China. While that may be true, that sort of defense ignores how important China has become to Herbalife in terms of growth. Last October, Herbalife was able to report earnings that exceeded analysts' expectations largely because of its 76.5% sales growth in China.
It's also interesting that Canaccord would downplay the importance of China -- back in 2012, before Bill Ackman made his case against the company, Canaccord was citing China as a reason to be bullish on the stock, arguing that it was destined to become one of Herbalife's largest markets.
The seven-year ban
That won't happen if the Chinese government bans multi-level marketing, or makes it much more difficult for Nu Skin, Usana, and Herbalife to conduct business in China. While there's no guarantee that will happen, harsh regulatory action would not be unprecedented -- the Chinese government has a track record of strong hostility toward multi-level marketing.
In fact, from 1998 through 2005, the entire business model was strictly illegal -- multi-level marketing companies could sell their products, but only through traditional retail outlets; the practice of recruiting and compensating, integral to multi-level marketing, was outlawed.
China lifted its restrictions on multi-level marketing in 2005, but there's still a web of regulatory hurdles, including a requirement that companies obtain direct selling licenses from Chinese regional governments.
Could Chinese policymakers influence the FTC?
After seeing his short position move against him, Ackman will make a presentation next week arguing that Herbalife is operating an illegal pyramid scheme in China. So far, it seems that his allegations have fallen on deaf ears in the U.S., but given China's long-standing opposition to multi-level marketing, he may have far more success convincing the Chinese government to intervene.
Analysts at Deutsche Bank have argued that the Chinese probe of Nu Skin will be short-lived and result in a modest fine. While that's possible, I wouldn't be so certain. The sell-off in shares of Usana, Nu Skin, and Herbalife seems more than justified given the potential fallout that could occur should the Chinese government revert to its old ways.
Fool contributor Sam Mattera has no position in any stocks mentioned. The Motley Fool has the following options: long January 2015 $50 calls on Herbalife. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.