Rightly so, I took some heat from comments in my previous article about GNC's Debt (GNC: A Story of Free Cash Flow) because other investors and SA contributors stated that EV/EBITDA was a more accurate valuation measure than EV/FCF. Point taken. Nevertheless, I am glad to see that cooler heads prevailed in interpreting the main thesis to my argument: Namely, that GNC's debt situation is trepidatious, and the company needs to take swift measures to refinance to restore Wall Street's confidence.
While I have written at length about GNC's debt situation, I learned a tremendous amount from my private conversations with other investors on SA. For that matter, I have learned that it is even more important than I originally suspected that GNC refinance the Senior Credit Facility ($1.3 billion) due to the fact that debt is floating and not fixed interest rates. And they need to do this soon. Notably, GNC's senior credit facility - the Revolving Credit Facility due Sept. 18 and the Term Loan facility due March 2019 - are based on floating interest rates.
Page 49 of the 2016 10K shows the details of the Senior Credit Facility floating rate agreements. Basically, GNC is charged interest of 1.25% on the Revolving Facility and 1.5% on the Term Loan Facility plus the greater of one of the following mostly-floating interest rates:
- JP Morgan Chase Prime Rate
- Overnight Federal Funds rate +.5%
- One Month LIBOR plus 1.0%
- 1.75% (applicable to Term Loan Facility Only) - This is the only non-floating rate in the bunch
In short, GNC's debt interest is exposed to federal interest rate hikes, or floating rates. This means that GNC - like homeowners that finance with teaser rate adjustable mortgages - are gambling with interest rates that may increase. Below is a chart of the effective federal funds rate from 1955 to the present day:
As of July 2017, the effective federal funds rate stood at 1.15%, which is incredibly low given historic comparisons. I don't think there is any point in trying to forecast what the federal interest rates will do in this article; your guess is as good as mine. Nonetheless, the sub-prime mortgage crisis is a good example of what can happen when borrowers rely on teaser adjustable rate loans without proper caution for what can happen should floating rates rise. I hope GNC remembers this history lesson going into the back half of 2017.
Looking at GNC's 2016 10K income statement, EBIT (earnings before interest and taxes, similar to operating income) was $303.6 million, assuming you exclude the $476.5 non-cash asset impairment charge in the fourth quarter. Now, I will make a few assumptions for forecasting to show readers who could happen in different interest rates scenarios. Of course, readers are welcome to critique my assumptions in the comments; however, I want to be clear that my assumptions are general in nature and not meant as specific indicators as to what I think GNC will do this year. Ok…here we go.
In 2016, GNC interest payments were $60.4 million - or 19% of EBIT - and interest rates were at about 3.26% on the Senior Facility, due to historically low floating rates. Assuming that 2017 is similar to 2016 - meaning EBIT stays flat and debt levels stay the same - then the following scenarios could occur:
- If interest rates rise 1% higher than 2016 levels, interest payments increase $16 million and make up 25% of EBIT
- If interest rates rise 2% higher than 2016 levels, interest payments increase $32 million and make up 30% of EBIT
- If interest rates rise 3% higher than 2016 levels, interest payments increase $48 million and make up 35% of EBIT
I'll stop there, since you get the point. For every one percent interest rate increase, GNC loses $16 million in operating income. And looking at the federal funds rate chart, you can see that a 2% Y/Y interest rate hike is not unprecedented, which should give pause to any GNC investor. Indeed, it happened as recently as 2004-2005, when the rate rose from 1.04% in June 04 to 3.25% in June 05. The federal funds rate has already increased .5% from January to July of 2017, which will impact GNC's profits.
While I remain long GNC because I believe in the myGNC turnaround and Robert Moran, I would argue that the real turnaround in the stock price will largely be dependent on refinancing the debt, hopefully to the tune of 4% or 5% fixed rate, which is a rate that won't cripple the company should inflation cause feds to raise interest rates rapidly. By comparison, interest payments on the Senior Credit Facility were 3.27% and 3.25% in 2016. Of course, I would love to see GNC refinance at fixed rates of 3.27%, but I think that's unlikely given we're only two quarters into the turnaround and Mr. Market is freaking out about Amazon taking over the entire retail sector.
If GNC can change their debt horizon, I predict that will ignite another short squeeze. More specifically, if that occurs, intelligent investors should look closely at the refinancing structure and see if the interest rates are fixed at a reasonable rate. Back in May 2017, Bloomberg reported that GNC likely walked away from a potential debt refinancing with Apollo Global Management LLC when Apollo was asking for 750 basis points (7.5%). That rate would be about double the interest rate GNC paid in 2016, which shows where the sentiment is for GNC debt at the moment.
In short, 4-5% fixed rate on the Senior Facility would be a win for GNC and - I would argue - for the debt holders, assuming the turnaround continues to trend positively.
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.