When evaluating Q1 results, it appears the turnaround strategy is working, and after I performed a few channel checks in April, the Q1 momentum continuous into Q2.
My rationale for an investment in a particular stock is summarized in the 5 sections below and follows most of Benjamin Graham's "The Intelligent Investor" principles.
- Understand the business you are investing in
- Know who runs the business
- Invest for profits over time (look at historic and future EPS growth as this will drive stock price over time)
- Have confidence in own reasoning
- Invest with a margin of safety (current price is at least 50% below intrinsic value)
As it pertains to GNC Holdings, Inc (NYSE:GNC):
I) Understand the business you're investing in (Source: GNC Company Information)
GNC is a leading global specialty retailer of health and wellness (H&W) and performance products with around 9,000 stores globally. Products include primarily vitamins, minerals, and herbal supplements products (VMHS), sports nutrition, and diet products. GNC is ranked sixth in the US in 2016 with 2 % "value share," in vitamins and dietary supplements category and 4 % value share in the sports nutrition category, ranking fifth in the category.
As per the company Q1 financial statements, it operates a multi-sales channel business as per table below:
Description Total number of Stores US & Canada Company Owned Stores 3,500 Domestic Franchise 3,535 = Rite Aid (2,371) + 1,164 International Franchise 1,949 Other 3rd party contract manufacturing, e-commerce
Most of the company-owned stores are in shopping and strip shopping centers. Geographically, total sales are:
Geography % of Sales US and Canada 85% International 7% Mfct and WS 8%
II) Know who runs the business (Warren Buffett: Buying into retail with bad management is like buying the Eiffel Tower without an elevator)
Joe Fortunato, was the CEO from 2005 until 2014 and during this time helped EBITDA jump from $113 million to $526 million. He guided GNC to a successful IPO in 2011 on the NYSE. He continued to raise prices and infamously in July 2013 gave 3 million one year Gold Card member passes for free vs. charging the standard $15 annual fee. He started a $500 million share repurchase program in November 2013 at a time when borrowing money was cheap, but the stock price was trading at all-time highs.
In August 2014, Mike Archbold was appointed as the new CEO. He was previously the President and COO of GNC's largest competitor, Vitamin Shoppe. He continued with the borrowing to support the share buyback program. Coincidentally, when he took over, he expressed concerns about the current pricing strategy and that the Gold Card program needed an overhaul following May 2013 changes. However, appears that any changes had only a minor impact and seems his focus was more about keeping the stock price at artificially high levels.
Given a series of disappointing results, a new interim CEO, Bob Moran, was appointed in July 2016. He has over four decades as a successful retail executive and demonstrated proven ability to lead organizations in highly competitive environments. Before GNC, he was the CEO of Petsmart, which he helped turn around and which eventually sold for $8.7 billion on just over $2bn of sales in 2015. Following a 90-day review of GNC business, he described the current business model as badly broken and in need of change. At the end of 2016, he rolled out a new strategy focused on five areas/pillars going forward 1) Retail customer experience 2) Pricing 3) Loyalty program 4) Product innovation and 5) Marketing.
The company tested a new single tier pricing strategy in a total of 500 pilot stores in September and October 2016. These pilot stores were tracking flat to slightly positive SSS growth by end of Q1. I assume these encouraging results had some level of influence on Mr. Moran's decision to acquire around 593K GNC shares for $5 million on the open market (Avg. price around $8.40) in February 2017. The purchase represented around 1% of the outstanding shares of GNC at the time, and other directors followed suit and bought north of $1 million of shares in Q1 on the open market.
The current CFO, Tricia Tolivar has been with GNC since Q1 2015. Before GNC, she served in leadership positions with Ernst & Young, LLP from October 2007 to February 2015, including as Americas Director of Finance and Advisory with responsibility for the leadership of finance, accounting, and operations. She also previously served as CFO of the Greater Memphis Arts Council from January 2006 to December 2008 and held a series of executive leadership positions with another specialty retailer, AutoZone, Inc. from 1996 to 2005.
III) Invest for profits over time (look at revenue, margins, and earnings growth over the last couple of years)
Revenue:
After two straight years of 1% expansion, the company's top line fell 5.3% in 2016 which is considered by many the "reset" year as it involved the change in leadership and introduction of a new business model on December 30th. Despite the lower than expected 2016 results, sales are still 25 % higher than when it listed in 2011 and on track to be > $2.5 billion in 2017 for a 5 Yr. CAGR of 4.2%. (Source: Author's calculation)
Gross Margins:
Gross margins have been slowly deteriorating over the last four years after peaking in 2012 at over 38% and reached a bottom of 33.4% in FY 2016. The decrease is driven primarily by increased price competition. In 2017, GNC is reducing the number of promotions which will support gross margin to get back to 34%. This is on par with industry averages and 100 basis points above Vitamin Shoppe, its closest pure play competitor.
Earnings and Operating Margins:
Similar to gross margin, GNC's operating margin and net margin also experienced a strong period leading up to 2012, at which point they stagnated and began to decline coinciding with the changes made to the Gold Card loyalty program in 2013. Even after adjusting for a large non-cash impairment charge in 2016, the downward trend in margins continued with year-on-year declines of +25% when comparing the 2016 to 2015 period.
From reviewing the above charts, starting in 2013 and up until the end of 2016, most operating metrics were in a downward spiral. However, below are some factors that will help revive future growth.
- The company-owned store's transactions during Q1 vs. PY: January up 7.5%; February up 7.8%; and March up 11.7% (there was a marketing push in March) for an average of +9.3% vs. -6.5% in Q4.
- The overall company owned SSS was down 3.9% vs. Wall Street estimate of -6.5%. What is noteworthy is the composition of the 3.9%: transaction volume up 9.3% ("GNC has not seen such a significant increase in many years" as per CFO) which was offset by basket size being down 12%. International SSS were up 3.8% and domestic franchise stores SSS were down 4.6% with transactions up 4.2% but offset by lower basket sizes by 8.4%.
- Most encouraging are the results from the ~500 (or 14% of all company owned stores) September (249) and October (228) 2016 pilot stores reported at end of Q1. These stores are tracking 5% above the rest of chain. See below table from Q1 conference call:
As such, I would agree with the current CEO that they have managed to get customers back into the stores and now the natural next step is to focus on adding to consumers' basket size. Several promising initiatives have already been rolled out to achieve this such as the $9.99 Grab and Go products at checkout, more customized offerings via email, etc.
- Online sales are down 7% vs. 49% in the previous quarter: Since the January 2017 launch of Amazon Marketplace, GNC has been reviewed more than 5000 times and has a 93% favorable rating which would be hard to achieve if there were large price discrepancies. Also, the online segment currently represents only 9% of total sales but expect this figure to increase in Q2.
- More than five million registered myGNCReward members as of the end of March 2017: In stores where foot traffic is measured, store visits are way up and averaged 1.5x for Q1 vs. 4x per year under old Gold Card. Vitamin Shoppe has almost the same number of loyalty members which produce +85% of their total retail sales. GNC is +12x larger when considering their physical footprint and has 2x the revenues. Given the marketing push in Q2 and their size advantage, I would guess for sign-ups to be close to 8mm by the end of Q2. Finally, Pro Access membership is already 100K.
- Marketing initiatives are paying off: The new GNC commercial banned by the NFL is approaching 20 mm views, and the CFO mentioned they are seeing 3-1 ROI on Q1 marketing activities and therefore rolling those into Q2.
- Better information and CRM system: When signing up for the new loyalty program, an e-mail is required. This feature supports tracking buying behavior for more personalized offerings which will drive increased basket size. They have also brought data mining skills in-house (previously worked with Dunnhumby) so they are aware of the power big data analytics can have on sales. (For example: Kroger through its joint venture with Dunnhumby claims that 95% of sales are rung up on the loyalty card and has seen an impact from its award-winning loyalty program through nearly 60% redemption rates and over $12 billion in incremental revenue by using big data and analytics.)
- International only represents around 7% of total sales: China has less than seven stores on the mainland and Hong Kong, with only 7 million inhabitants, has 87 franchise stores. China's vitamins and dietary supplement market are expected to increase by 53% to $28.7 billion by 2021 and Chinese consumers are putting greater trust in Western brands such as GNC.
- The cumulative historical 5 year FCF is over $1.0 billion: Essentially with a broken operating model, the company was still able to generate free cash flow as per table below
| 2016 | 2015 | 2014 | 2013 | 2012 | |
| FCF | $149mm | $309mm | $233mm | $189 mm | $181mm |
to equal the LT debt due in March 2019. Therefore, I feel reasonably comfortable that if they can obtain at least a 3-year extension on the loan, that the new operating model will be rigid enough to support servicing most, if not all, of the outstanding long-term debt.
- Franchising to pay down the long-term debt: If GNC franchises all 3500-remaining company owned stores with average proceeds around $300K (Source: Author's calculation when reviewing q4 financials), then they will be able to service debt.
IV) Have confidence in your reasoning
In this section, I discuss what others are saying that are different that my opinion and try to provide a rebuttal.
a) Debt levels are too high: At the end of Q1 2017, GNC had outstanding long-term debt as per in table below:
Response: Given the projected future FCF and improving SSS figures, they should be able to pay off the revolver due Q3 2018. Also, the convertible is not due for three more years, so most of the fears are centered around the $1.1bn term loan due March 2019.
Likely one of three scenarios will unfold:
1) As 95% of the company owned stores are still CF positive, GNC could franchise the remaining 3500 stores and pay down the debt with the proceeds
2) they will keep growing SSS which will drive up both earnings and FCF along with the stock price. Bond holders will look at both the potential future free cash flows in addition to the equity cushion when considering refinance options. As such, unless general market conditions worsen and banks are unwilling to lend, like in the 2008 recession, improving the SSS to close to 0% should be sufficient to refinance the term loan due in 2019. The CFO also said on the Q1 call that there is no risk of breaking the loan covenants in 2017.
3) GNC is bought out by US or Chinese investment firms who will then restructure the debt. (when rumors surfaced of the potential acquisition in 2016, the price was over $24 per share)
b) There is little value in being a distributor which has great in-store experience as online resources far exceed the value you can get from any clerk. For example, Bodybuilding.com and Amazon.com provide an unlimited amount of research and reviews:
Response:
Person to person and store experience are key to driving customer satisfaction in retail, and therefore profits, especially when selling proprietary products. Over 50% of GNC products are proprietary and people want to know what they consume. However, who wants to spend hours online researching, when you can walk into your neighborhood GNC store with a friendly, well trained, and therefore trusted advisor, who gives you the same information in seconds.
c) The death of brick and mortar: Several retailers have shut down stores or all together:
Response: When analyzing the data, these are primarily non-specialty retailers (Macy's, JC Penney, Sears, Kmart) or specialty retailers selling items such as books (Barnes and Noble), clothes (Bebe, American Apparel, Guess, Abercrombie and Fitch, Payless Shoe Store, Rue21, The Limited), electronics such as PC (RadioShack, HHGregg). In other words, there is no real competitive advantage, no proprietary merchandise requiring a great shopper experience, or unique pricing model. If you think about Warby Parker, Home Depot, Lowe's, these retailers are all expanding their store footprint as they put shopper experience as a top priority (consistent with new CEO focus to provide customized offers, seamless checkout, professional advice, new products trials, and free home delivery).
V) Invest with a margin of safety (buy the stock at a price when it is 50% lower than my estimate of its intrinsic value)
Recently, the stock has been trading between $7 and $7.50 per share.
- Preparing a 10-year Discounted cashflow (DCF) model given the new operating model does not make sense. However, applying a 10x capitalization rate (50% lower than the Avg. P/E ratio since 2011 IPO) to my estimate of normalized earnings and without considering replacement of Gold Card fees or further international expansion, results in a stock price of $19 and therefore more than 2x current price.
- Alternatively, taking the 2016 adj. EPS of $2.15 and applying a more conservative 8x capitalization rate results in a $17.2 stock price. Again not considering any material operating improvements, results in a price that is more than 2x the current price.
- Q1 revenue was $654mm and traditionally represents around ~26% of FY sales. When extrapolating this figure, GNC should deliver at least $2.5bn in FY17 sales, and with the current market cap around $500mm, this represents a Price/Sales Ratio of 0.20. This is significantly lower than peers who are closer to 0.5 or even 1. As such, when assuming a P/S ratio of 0.5 the resulting market cap is $1.25 billion or $18 per share. Again this is more than 2x the current stock price.
- Lastly, when considering international expansion, an improved omni-channel experience, and flat SSS, it should not come as a surprise to see GNC trading again at $30 per share in next 3 years.
Marius Swart
I am a value investor and follow most of Warren Buffett's principles. I therefore make few but infrequent and big bets and also invest other people's money. My average holding period is around 2 years and I look for investments which have a 30% margin of safety before investing.I prefer to look at companies that are in FMCG or retail space as I have over 16 years experience in these.
Analyst’s Disclosure: I am/we are long "GNC". I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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