Uncertainty at NBTY Offers Opportunity

 |  Includes: NTY, NWL
by: Stephen Castellano

NBTY, Inc. (NTY) closed down 20.6% Tuesday, $9.66 to $37.24, knocking off $610m in market value. It was the worst performer in the our "high-quality" model portfolio, the S&P 400 MidCap Index (down 2.42%), and the second worst performer in the Russell 1000 Index (down 2.35%). At around 2:10 PM on the 27th, with the stock closer to $30.05, we alerted our readers via Seeking Alpha's StockTalk, Twitter and StockTwits that we thought the sell-off was absurd. What follows is a lengthy explanation of that viewpoint previously expressed in 140 characters.

The NTY stock price has run into the perfect storm composed of: 1) a general market sell-off; 2) release of financial results Tuesday morning showing a huge $0.20 EPS miss versus the consensus average of $0.93 and $0.14 below the consensus low of $0.87; and 3) a downgrade by at least two sell side firms; 4) the stock's relatively small market cap (62.3m shares, 51.6m float) which probably made it difficult for EPS-momentum program strategies and headline-focused investors to get out of the stock efficiently. The EPS miss and likely negative analyst revisions to follow will, without a doubt, knock this stock off of our quant-driven "high-quality" model portfolio.

Analysts Focused on the Negatives, and Management Could Have Handled the Call Better
We understand the impulse to sell and ask questions on a 22% EPS miss, especially given the company's volatile trading history (it has moved from the teens to the $50s twice over the last five years). And to be fair, the conference call could have been handled better by management.

There were nine sell side analysts on the conference call, each one seemingly in a high state of anxiety. Despite a solid revenue figure of $705m, which was ahead of consensus of $682m, and an in-line gross margin of 46%, analysts did not like being surprised by $18m higher than budgeted advertising spending. That, and some other "moving parts" attributed to SG&A, helped drive operating profit of $79m, up 78% over last year but still short of consensus by $21m. The repeated nagging questions by the analysts on the call about the SG&A line seemed to indicate both a complete befuddlement over the concept of opportunistic, success-based advertising in order to take additional market share, or worse, a stunningly complete lack of credibility in management.

Management also indicated gross profit margins would be lower next quarter as a result of price pressure. They would not quantify the potential impact on margins, but said that it was reacting to price pressure as competitors were trying to take back market share that NBTY had previously won. When asked about raw material pricing pressure, management said that some prices were up and others were down - not the quantifiable answer the analysts were looking for.

In addition, some analysts may not have liked that the overall growth in NBTY, Inc.'s "marketplace for nutritional supplements" grew 13.3% for the 26 weeks ended April 3, 12.5% for the 13 weeks ended April 3 and 10.3% for the month of March since it could be indicate a near-term softening of demand.

Sell Side Needs to Focus on What Matters
Explanations from management like "we can't predict the future", while true for most companies, could have been more eloquently phrased in order to put the analysts more at ease. Perhaps NBTY, Inc. should take a page out of CEO Mark Ketchum's playbook at Newell Rubbermaid (NWL). Ketchum is a master of setting analyst expectations by providing clearly defined possible target ranges and providing SG&A targets that always seem to leave room for opportunistic, success-based advertising and marketing spending.

At the same time, the sell side needs to stop demanding to be spoon fed every detail of information and learn to make their own independent assumptions and forecasts. There are many moving parts that must be managed to run a business, and often there is only clarity in retrospect, even internally. The lack of clarity that management provided on the call does not seem symptomatic of some hidden conspiracy to mislead investors. In any case, we came up with some of our own assumptions that are even more negative than a compilation of the worst consensus forecasts. If our assumptions are correct, investors should be fine purchasing the stock at the current price. If there is any upside to these dire forecasts, the stock should respond accordingly.

Prior to looking at the detailed figures in the tables below, let's take a look at quarter highlights at NBTY, Inc., all very positive:

  • Sales up in every segment, up 18.4% overall to $705.2m.

  • 370 basis point improvement in gross margin up 46%.

  • A 170 basis point improvement in SG&A, excluding advertising, despite a $20m absolute increase.

  • EBITDA up 57% to $99m, or 14% of sales.

  • Despite a potential softening in the category growth, NTY is growing almost double the category

  • Taking share from competitors.

  • $200m cash.

  • 4.2m share repurchase authorization left.

  • Paying down debt, now at $376m versus $464m last year.

  • Successfully integrating recent European purchase.

  • Finding opportunities to leverage success-based advertising opportunities that may generate years of payback.

  • Track record of improving ROE, improving CROC, improving ROIC and improving free cash flow.

  • Making assumptions even worse than the consensus low, a likelihood to still produce positive free cash flow and mid-teen ROIC, above the cost of capital.

  • At $37, a 11.6x multiple on a calendar-year 2010 EPS estimate of $3.20 (assume the worst, and take $0.20 cents off the next three quarters).

  • Anxious sell side analysts, unquantifiable gross margin pressure, advertising spending an uncertainty

Note that margin pressure does not in and of itself lead to free cash flow and ROIC pressure. And even if sales growth slows and margins decline sharply by around 600bp, ROIC should still come in at a low-to mid-teen rate, and the company will still be generating positive trailing 12-month free cash flow.

A worst case multiple on worst case EPS could get you to about a $45 stock price (14x $3.20). Portfolio managers requiring a midcap consumer staple name should use the anxiety around this stock to their advantage. A detailed scenario analysis may follow.

A pdf of this report is available on Scribd.

Risks and disclaimers
Investing in any stock entails a high degree of risk, including the risk of entire loss. We are not soliciting the sale of securities. We do our best to provide accurate and relevant analysis, but we make no guarantee.

Implied by Consensus Worst-Case, Not Updated for 3/31/2010

Ascendere Associates LLC Worst Case Assumptions, Updated for the 3/31/2010 Quarter

Implied by Consensus Worst Case

Implied by Consensus Worst Case

Ascendere Associates Worst Case

Ascendere Associates Worst Case

Disclosure: None