Encouraged By Chattem's Pipeline: Guaranteed Growth in Uncertain Times?

Chattem (CHTT) makes and markets a diverse portfolio of branded personal care products, over-the-counter [OTC] pharmaceuticals, and dietary supplements.

It reports domestic sales for seven product categories:

1. Topical Pain Care Products, which produced 23% of sales for the first nine months of 2007, include muscular and arthritis pain relievers such as Icy Hot, Aspercreme, Flexall, Capzasin, Sportscreme, and Arthritis Hot.
2. Medicated Skin Care Products produced 29% of sales. They include Gold Bond, Cortizone, and Balmex.
3. Medicated Dandruff Shampoos, which were responsible for 8% of sales, are sold under the Selsun brand.
4. Oral Care Products generated 11% of sales. They include ACT mouthwash, Herpecin-L cold sore balm, and Benzodent denture pain relief cream.
5. Internal OTCs, which produced 10% of sales, include Unisom sleep aid, Kaopectate anti-diarrheal, and Pamprin and Premsyn menstrual pain relievers.
6. Dietary Supplements, which generated 7% of sales, include Dexatrim weight loss products, Garlique cholesterol supplements, Melatonex sleep aids, New Phase menopausal supplements, and Omnigest EZ digestive aids.
7. Finally, the Other OTC and Toiletry Products category, which produced 5% of sales, includes Bullfrog sunscreen, UltraSwim chlorine removing shampoo, and Sun-In hair lightener.

The remaining 7% of first nine month sales came from international markets. CHTT offers a limited selection of brands in Europe, Canada, the Caribbean region, and Latin America. This category also includes royalties collected from third party distributors. The company tries to hold leading positions in niche markets that are not priorities for larger competitors.

Growth is driven through brand extensions, new products, and acquisitions. CHTT acquired five Johnson & Johnson brands in Q1 for $410 million. CHTT has recently struggled with two brands: Icy Hot Pro-Therapy and Dexatrim. Advertising and promotional spending was too aggressive for the former, and competitive pressures hurt sales for the latter.

But acquisitions and strength in other products more than offset these problems. Nine month sales were up 37.1% year-over-year. Fiscal Q3 net sales jumped 51.3% year-over-year to $109 million. Five of its six largest brands grew at double digit rates. The gross profit margin improved 79 basis points.

Excluding a favorable $10.8 million litigation settlement in the prior year, the Q3 pro forma operating profit margin expanded almost 900 basis points to 30.10%. Pro forma net income jumped 96.88% to $17.53 million or 90 cents per share. GAAP net income was $16.31 million or 84 cents per share, which compares to $15.23 million or 81 cents per share a year earlier.

CHTT operates in a competitive industry against giants such as Procter & Gamble (PG) and Johnson & Johnson (JNJ). Its ten largest customers accounted for 73% of fiscal 2006 sales. Wal-Mart (WMT) alone accounted for 36%.

Despite such risks, we are encouraged by the product portfolio and expect business to do well even in uncertain economic times.

In addition, year-over-year comparisons for Dexatrim and Pro-Therapy should improve. Management has been raising earnings guidance based largely on progress in integrating acquired brands, a promising pipeline of products, expected reductions in debt, and further cost efficiencies.