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Introduction

GNC is a leading sports nutrition company that I wrote about over a year ago on Seeking Alpha. Since then, GNC has exceeded initial expectations, growing top and bottom line through quite strong same-store sales growth. However, my analysis did not estimate the intrinsic value of the firm, and I had no idea if the current run-up was warranted and if GNC is still a good investment.

Much of the original thesis remains: the firm remains exposed to a growing industry, possesses operating leverage, and has exhibited a tremendous ability to maintain prices. Yet there are some concerns about the firm including regulation of products and more significantly price competition from internet sources. While these concerns are valid, the downside, considering the low probability of the event, is not significant. Assuming GNC can maintain some price stability, not get squeezed by suppliers, and grow at widely accepted rates, GNC appears at least 40% undervalued.

Business Description

GNC operates in 3 distinct segments: retail, franchise and manufacturing/3rd party. 2012 full-year results for revenue and operating income give an idea about the relative size of these segments.

Source: GNC 2012 10-K

While these 3 segments achieve the same goal, deliver nutrition products to consumers, the mechanics of the 3 are very different.

In retail, GNC owns the distribution point, whether that is the 3299 company owned stores, or the rapidly growing GNC.com and luckyvitamin.com. Almost all of GNC's retail operates in America. GNC must make the initial investment, manage the stores, and incur costs like employees and rent in addition to product, warehousing and distribution costs, which make up the majority of the costs of the other two segments.

However, there are some significant benefits to this structure. The company is able to exert much more control over day-to-day operations of outlets ensuring efficient management and maintenance of the brand. Retail operations have allowed the company to benefit from significant operating leverage, as its margins have grown significantly more than the other segments over the past.

Note: Franchise Product Sales is Franchise Operating Income minus royalty and franchise fees divided by franchise product revenue.

In the franchise segment, GNC only provides startup assistance to independent owners. GNC makes money through franchising in 4 different ways: product sales to franchises, royalties on franchise sales (6% domestic and a stated lower amount for international franchises), initial and renewal franchise fees, and other which is often related to financing locations. Royalties and fees essentially flow directly to the bottom line. While financing does require GNC's capital, it too requires few costs. Consequently, almost all the costs in this segment derive from product sales.

The benefits of franchising include a consistent stream of income, guaranteed volume for GNC's wholesale operations, negligible capital expenditures. However, GNC does not get to experience the operating leverage nor exert the quality control that it does in the retail segment.

The franchise segment represents GNC's international exposure. GNC currently has 984 domestic franchises, and 1955 international franchises. However, domestic franchises have generated revenue of about $200MM through 3 quarters this year compared to about $137MM for international franchises. This difference is the result of international stores being significantly smaller than domestic franchises, carrying ½ the SKUs, and generally being younger franchises. Domestic franchises also make up a major portion of royalties, because their royalty rate is higher than that for international franchises. Finally, initial and renewal fees for international franchises are typically about 60% of domestic fees.

Franchising offers GNC an easy way to tap into international markets. GNC makes no capital investment and can rely on local savvy businessmen to adapt to the unique business climate. If models prove successful here, GNC could shift its retail expansion into international areas.

Finally manufacturing/3rd party makes money by supplying items to franchises and retail segments and stocking 3rd party distribution points such as Rite-Aid, Sam's Club and other locations. This segment has generally grown along with company sales, and has maintained a relatively constant margin.

Industry And Macro Trends

GNC, through VMHS (Vitamins Minerals and Herbal Supplements), sports nutrition, diet and other products, is exposed to the supplement industry. These areas are growing quickly due to a variety of factors including, but not limited to, increased activity levels of people in response to health issues and aging, improved awareness of the impact of supplements, and increased wealth. Additionally, the industry is undergoing a shift towards online retailers, with online revenue expected to grow significantly faster than brick and mortar revenue.

On the low end, the supplement market is expected to grow at 4.65%. However, more estimates are higher. A recent Wall Street Journal article estimates growth between 5% and 7%. An interpretation of data from a recent Forbes article implies an approximately 8% growth rate.

GNC and Vitamin Shoppe (NYSE:VSI) call for similar industry growth rates. GNC states in its most recent 10-K: "Our industry is expected to grow at an annual average rate of approximately 6.5% through 2020. As a leader in our industry, we expect our organic retail revenue to grow faster than the projected industry growth as a result of our disproportionate market share, scale economies in purchasing and advertising, strong brand awareness and vertical integration."

Sources: VSI William Blair Presentation, GNC 2nd quarter investor presentation

An application of Vitamin Shoppe's segment growth rate to GNC's revenue segments similarly yields growth rates of 6.5% and greater through the years. All evidence a strong industry moving forward.

A major negative macro industry trend is increased regulation. The FDA has recently issued guidance calling for more guidance and oversight, which currently appears minimal, of the supplement industry. While more regulation hurts the whole industry, GNC may be particularly affected because it is often hesitant to pull products. The banning of a product could take a chunk out of GNC's sales, but GNC would likely recover as it did with Hydroxycut in 2009. While increased regulation on something such as labeling may impose higher costs on GNC, if it is industry wide, GNC should be able to pass along these costs. Further, GNC is somewhat insulated from regulation because the majority of its products are produced by 3rd parties.

Competition

GNC's main competitor is Vitamin Shoppe. However, the market is extremely fragmented creating a range of customers from supermarkets to drug stores. Moving forward, internet sources, principally Amazon, may become the true threat.

GNC's and Vitamin Shoppe's models are very different. GNC aims for retail stores to be between 1000 and 2000 square feet, with international franchises noticeably smaller, while Vitamin Shoppe's stores have historically been about 3600 square feet according to its presentation at the William Blair conference. GNC typically targets strip malls and malls, whereas Vitamin Shoppe typically targets stand-alone locations. GNC typically offers about 1800 SKUs in its retail stores whereas Vitamin Shoppe can stock up to 8000 SKUs. GNC franchises stores and has a manufacturing division while Vitamin Shoppe does not. GNC pays employees at stores significantly based upon commission while Vitamin Shoppe salaries employees. GNC has a much more developed proprietary product line (55% of retail revenue in 2012) compared to Vitamin Shoppes (22% revenue in 2012)

Vitamin Shoppe is known for being cheaper than GNC, but this may actually prove untrue. A quick but random sample of 7 popular and varied products was taken from gnc.com, vitaminshoppe.com, and amazon.com. These prices include shipping costs.

Normally GNC is on average about 10% higher than Vitamin Shoppe prices, which agrees with Vitamin Shoppe's statement in its presentation that its prices are 5%-15% lower than specialty retail. However, GNC member pricing is actually 5% lower than Vitamin Shoppe pricing suggesting that GNC may be more price competitive than some may think. This impression may result from GNC branded products that are typically more expensive than similar third party manufacturer's similar products.

It's not really possible to say which business model is better. GNC's smaller store format gives it greater location flexibility. Additionally, GNC's store locations allow for customers of other stores to wander in. Yet sales per square foot are nearly identical at approximately $350/sq. ft. and $360/sq. ft. for GNC and Vitamin Shoppe respectively. While a consumer may not want someone who makes money based upon commission, most GNC consumers don't know GNC employees earn commission. This reward structure may allow GNC to up and cross sell products. Additionally, GNC's narrow focus (1/4 SKUs) combined with its size may allow them to leverage suppliers in ways Vitamin Shoppe cannot. Finally, GNC is more vertically integrated than Vitamin Shoppe with its manufacturing segment. For potentially these reasons and others, GNC has been able to achieve a higher EBITDA margin, 21% in 2012 than Vitamin Shoppe has with its mature stores at 16.6% EBITDA margin.

Overall, it does not appear that Vitamin Shoppe will outcompete GNC over the short and medium term. However, Amazon and other online retailers present a unique threat by truly being more price competitive than GNC and by extension. The competitive dynamic is summarized nicely by Vitacost in a recent investor presentation.

This further supports the idea that GNC and Vitamin Shoppe are actually pretty price competitive. However, according to the random samples above, GNC is noticeably more expensive than Amazon. A more comprehensive study from Wells Fargo finds Amazon to be on average 15% below GNC and Vitamin Shoppe, and the above Vitacost presentation found less than a 10% difference between Amazon and Vitamin Shoppe.

There could be many reasons, sustainable and unsustainable over the long run, why GNC has been able to maintain costs significantly above Amazon. Chief among the unsustainable is lack of customer awareness of Amazon's supplements offerings. People automatically associate GNC and not Amazon with supplements. But as Amazon becomes more and more the center of commerce, this factor should decline. Another unsustainable factor is lack of comfort buying products online.

Customers may prefer to buy products in the GNC store over online though for some permanent reasons. First, the store offers customers the ability to obtain products instantaneously and compare many more products at once. While GNC's employees may not be true experts, as a whole they should offer some valuable advice that Amazon won't be able to copy. Even if GNC employees cannot provide advice, they can up or cross sell in ways a website cannot.

GNC may also be able to continue to charge higher prices due to the nature of its customers. Customers are very loyal, as seen by gold card members going up from 4.9MM in 2010 to 6.0MM 2 years later. These customers spend approximately twice as much as other customers. Furthermore, GNC's customer base is generally affluent allowing them to pay for apparent quality and making them somewhat insensitive to prices.

Additionally, GNC appears to have structured prices to be more competitive with Amazon's prices for relatively expensive items. This should help GNC maintain its prices because demand is more elastic at higher price points.

While Amazon and other discount retailers may gain share in the coming years, GNC could still take share due to market fragmentation:

GNC could easily take market share from mass retailers such as Wal-Mart or Target, and drug stores such as CVS or Walgreen as customers realize the benefit of shopping at a specialized store with a greater selection of supplements.

GNC appears well positioned within the industry. The key risk appears to be price competition from online retailers and not headwinds to top line growth. GNC's ability to sustain a higher margin than Vitamin Shoppe will allow it to better weather the storm from Amazon better than Vitamin Shoppe.

Store Expansion

GNC has managed its retail store base and franchise base extremely well. Since 2005, GNC has been able to grow revenue per store, including the recession, at 4.3%. However, since 2010, GNC has grown retail same-store sales at nearly 8%.

US franchises have grown sales at approximately 8.5%, while international franchises have grown sales at about 6.5% since 2005. International franchise revenue/stores has been somewhat held back the rapid proliferation of franchises. Many US franchises, however, have been closed over the same time period; thus only the most profitable and likely fastest growing survived. Franchise same-store sales growth has increased since 2010 similar to franchise growth; international franchises have grown about 8.4%, while domestic franchises have grown at about 11%.

Given this success, GNC plans on significant further retail and franchise expansion. Regarding franchises:

About Franchises in 10-K: Although we do not anticipate the number of our domestic franchise stores to grow substantially, we expect to achieve domestic franchise store revenue growth consistent with projected industry growth, which we expect to generate from royalties on franchise retail sales and product sales to our existing franchisees. As a result of our efforts to expand our international presence and provisions in our international franchising agreements requiring franchisees to open additional stores, we have increased our international store base in recent periods and expect to continue to increase the number of our international franchise stores over the next five years. We believe this will result in additional franchise fees associated with new store openings and increased revenues from product sales to, and royalties from, new franchisees.

This agrees with GNC's intentions of expanding internationally according to its February investor presentation:

Regarding retail, the firm's most recent conference call illustrated its plans:

"We are confident in our ability to maintain domestic store growth of approximately 115 net new stores each year for the foreseeable future. This plan is supported by an updated market research assessment confirming the potential for approximately 5,000 total standalone GNC stores in the United States"

GNC had 3,299 stores open at the end of the 3rd quarter. Consequently, GNC still has room for expansion before market saturation.

While GNC may not be able to continue growing stores and franchises at double digit rates as it has recently, consistent growth at historical levels should be achievable. Furthermore, it appears that GNC is ready to take advantage of favorable industry trends through expansion.

Margin Expansion

GNC's cost structure and leverage will allow it to expand its bottom line faster than the top line, assuming nominal same-store sale growth.

GNC controls variable costs very well. Many employees are temporary and are paid based upon incentives such as commissions ensuring GNC only pays for performance. Distribution costs are significant but GNC has been able to reduce them via vertical integration. GNC's largest cost is likely product. GNC focuses on a small number of suppliers, and is often these companies' largest customer. For example, GNC made up 12% of Musclepharm's revenue in 2012. GNC has significant leverage, because GNC's business is more important to often small suppliers than these suppliers' business is to GNC. Evidence of this stability comes from graphs illustrating the relationships between segment revenue and non-rent/D&A costs:

Given the above results, and the dynamics of GNC's supply chain, GNC should be able to control compensation, distribution, and material costs, with some opportunity for margin expansion due to some of the fixed assets.

The main source of margin expansion will come from leverage over rental expense and centralized corporate costs. GNC's rental expense depends upon the number of retail stores it has and the average rent expense. GNC has executed a highly disciplined retail strategy through which rent/store has grown at less than 2% per year since 2005 and even lower in recent periods. This is in spite of the shorter term lease agreements (5 years vs. VSI's 10-year agreements) that GNC signs.

This is supported by GNC's statement in the Morgan Stanley Global Consumer Conference in November 2012 that the company's fixed leverage was at 2%.

As long as same-store sale growth can exceed 2% over the coming years, retail margins will continue to expand.

Centralized expenses, namely unallocated warehousing costs, and corporate costs, should continue to grow more slowly than sales due to a large fixed portion. GNC supported that in its most recent conference call when it said: "I mean we always talk about sort of a normal run rate growth in low single-digits, and I think that's probably respectable going forward." This is supported by historical results in which corporate costs have grown at approximately these rates.

Balance Sheet and Comparable Companies

GNC does have a significant amount of debt; at the end of the 3rd quarter, it was approximately $1.1B. The real risk with loan is that the loan is a variable rate. With rising interest rates, GNC is likely to face rising interest rates in the future. However, this loan is not due till 2018, so GNC does not have any significant upcoming obligations.

GNC has and will have to make working capital investments to sustain the business. However, GNC has strong control of the main parts of working capital. Inventory levels have remained steady at just above 20% of revenue, indicating GNC is not stocking the channels precipitating price falls, and accounts payable similarly in the mid-single digits, indicating continued strong relationships with suppliers.

Vitamin Shoppe is GNC's only true competition; however, other companies such as Walgreen (NYSE:WAG), CVS (NYSE:CVS), Whole Foods Market (NASDAQ:WFM), and The Fresh Market (NASDAQ:TFM) have also been included.

While the drugstores and supermarkets are exposed to very different industries than GNC, they do share some significant similarities. Namely, business plans of all are generally executed by brick and mortar stores across the country. Furthermore, attributes of the two may bracket GNC's position in some ways. The drug stores have a stranglehold on their industry, while the grocers face intense competition. GNC likely falls in between because while it is threatened by online, GNC is still the dominant industry force, and the main online competition is not focusing its business on supplements. On the other side, the drugstores are in a very mature market with middle class clientele and face uncertainty with healthcare reforms, while the grocers are exposed to the significant long-term trend of organic food, healthier eating and a wealthier clientele. GNC appears to have significant industry growth upcoming, but supplements are not as necessary as food.

Most significantly, these companies may illustrate that one is not paying much for GNC's growth. GNC is growing significantly faster than the drugstores and essentially at the same rate as Whole Foods; yet GNC trades in line with the drug stores and at a significant discount to the grocers.

Whole Foods SSSG:

Sources: Whole Foods 2012 10-K; WAG 2nd quarter Report

Finally, GNC appears neither over nor undervalued based upon historical FCF yield. It has traded at a FCF yield of approximately 4.8% since its IPO.

DCF

If current conditions continue, GNC is undervalued because it will be exposed to an industry growing in the mid-to-high single digits, is poised to take market share in a fragmented industry, and will be able to grow its bottom line even faster due to growth with cost controls and leverage. However, the threat of competition from online retailers is legitimate, even if it does not appear to be a major factor currently.

A DCF helps estimate how much GNC would be affected if competition became fierce, forcing GNC to permanently lower its prices. A 10% decline in prices should capture significant downside and is not an optimistic bear case. 10% represents 2/3 of the price difference between GNC and Amazon currently according to the Wells Fargo study, and some price difference between the 2 should exist into perpetuity given certain sustainable factors.

The price reductions would ripple through the company. GNC will certainly be able to trim compensation by about 10% because many employees are compensated based upon commission, and other major corporate employees are compensated based upon overall company performance; a price reduction in products would curtail both. Rental, warehousing and other overhead costs would likely remain the same as these costs are relatively fixed. Change in costs from suppliers, however, is uncertain. In the worst case scenario, suppliers would not budge on their prices and GNC would get squeezed. On the other hand, GNC may be able to force suppliers to reduce prices given the lower selling prices to customers.

On the franchise level, royalties would be proportionally hit by the price decrease. The price decreases would likely cause franchise closures, particularly domestic ones and not international ones because internet competition is likely less there, which impacts royalties and product while GNC could squeeze its franchises, it probably would lower its prices on supplies, to help keep them healthy.

On the manufacturing level, GNC would probably have to lower supply prices somewhat because its major customers are large national retailers such as Sam's Club and RiteAid. If suppliers have more power, GNC will actually have to lower prices left.

The following 2 bear cases are based upon whether prices can be passed along to suppliers. The main changes in the cost structure occur in the 2016 period or 2 years from now.

Bear Case 1: GNC is forced to lower prices 10% across the board and suppliers have power over retailers. No retail stores close. GNC is able to reduce retail COGS by 10% * proportion of costs made up by compensation for whole company, which nets to be approximately 2%. Domestic franchise store count takes a 20% hit and stops growing, but international franchise only takes a 10% hit and continues to grow. GNC reduces prices to franchises by 8% to help keep them afloat, but costs remain the same. In manufacturing, revenues decline by 5%, as large outlets demand price reduction for GNC products but suppliers have some power.

Bear Case 2: GNC lowers prices 10% across the board, and the stores have power over the suppliers. Consequently, the 10% drop in retail revenue is accompanied by a 5% drop in retail costs. In franchising, 10% of domestic franchises close, domestic franchise growth stops and no international franchises close. Product revenue declines by 10%, but costs do not because retailers have power over the supplier GNC. In manufacturing, revenue declines by 10% with no reduction in costs.

The put these scenarios in perspective, case 1 would cause 2012 operating income to fall to $232MM and margin to 10.5%, while case 2 would cause a decline to $254MM and 11.6% from an actual operating income of $430MM and margin of 17.7%. The above does not take into account reduction of franchise count.

Key revenue model assumptions for these models were:

Other key model assumptions were:

Note that the FCF yield for the base case is 5.5% to reflect the better industry conditions. Also, the model examines only the equity portion of the capital structure.

The first bear case does illustrate that there is legitimate downside if GNC is forced to lower prices by internet supplements and its suppliers, which is compounded by a decline in franchise store. However, this scenario appears highly unlikely because GNC would have to lose almost all its pricing power over consumers and suppliers. A more likely downside scenario would be if GNC can at least pass along price decreases to suppliers as is represented by case 2. In this scenario, the downside appears limited. If GNC is able to fend off significant internet competition, but without branching out into new sectors or gobbling up market share, the upside as represented by the case appears significant.

Catalysts

In no particular order

1) Continued progress from new Gold Card program

2) Lower costs from new shipping policies

3) Continued strong same-store sale growth illustrating price stability and taking market share.

4) Further penetration of online platforms

5) International expansion

Appendix

https://www.dropbox.com/s/v4zr4owaghh2iur/gnc%20numbers%20base%20DCF.xlsx

Source: GNC: Continued Top And Bottom Line Strength

Additional disclosure: The author has presented his own findings. He encourages all potential investors to perform their own due diligence.