GNC: The Joint Venture

Summary

• GNC’s forthcoming joint venture in China will have a material impact on the company’s reported financial results.
• The terms of the joint venture were modified in the most recent announcement which significantly reduced the short term value to GNC.
• The China business will be converted into a combination of equity earnings and wholesale revenues.
• We provide an initial outline sketch of the potential financial impact.

GNC (NYSE:GNC) is set to establish a joint venture with Harbin Pharmaceuticals early in the coming year (pending closing of the final preferred stock transaction) which will replace the company’s current business in China. The joint venture will impact the company’s financial results in various ways, not the least of which will be reduced near term operating income as a result of the effective transfer of a 65% interest to Harbin.

Moreover, while not discussed during the company’s third quarter conference call, the most recently announced terms for the joint venture differ from those included in the original joint venture announcement and are significantly less beneficial to GNC. In particular, the valuation of the China business has been more than halved under the current terms.

In this article, we discuss this change in the joint venture terms and provide an initial sketch of how the joint venture structure may impact the company’s operating results in the near and intermediate term. The sketch provides a starting point for developing further perspective on the impact and potential of the joint venture and represents one aspect of the company’s business being incorporated into our revised models based on the third quarter results and coincident joint venture announcements.

The Joint Venture Terms

The announcement regarding the modifications to the Harbin preferred stock transactions, in particular, the division of the preferred stock investment into three separate tranches, also included updated information on the structure of the proposed joint venture. The modifications to the structure were not discussed on the third quarter conference call but represent a material reduction in the value of the business and the short-term benefit to GNC.

The original joint venture terms, as outlined in the original joint venture and preferred stock announcements, were reasonably favorable to the company. The implicit valuation placed on the China business in the joint venture was around $70 million to $80 million, within the valuation range we’d developed in prior articles based on multiples associated with comparable acquisitions within the supplements and vitamins segment by Chinese companies.

The original framework, broadly speaking, anticipated the following:

• Harbin would contribute “over” $52 million to the joint venture entity in return for a 65% ownership interest;
• GNC would contribute its China business in return for $22 million in cash and a 35% ownership interest.

However, the modified joint venture structure announced with the modifications to the preferred stock transaction reduce Harbin’s cash contribution for the 65% ownership interest to $20 million and eliminates the cash payment to GNC while GNC continues to contribute the China business to the joint venture for a 35% ownership interest. The implied valuation of the China business is thus reduced from around $80 million to closer to $30 million, far less than the original valuation and, equally, far less than many of the more optimistic valuations of the business.

The loss of the $22 million cash infusion alone is rather significant despite its modest size given the exceptionally high interest rates on the company’s most recent long-term debt. The $22 million, if used to pay down the high interest rate term loan (B-2), would have resulted in annual interest savings of approximately $2.5 million, roughly equivalent to an ongoing contribution of $0.02 in annual earnings per share. Alternately, the cash infusion would have represented a significant proportion of the $50 million in convertible notes that the company must redeem before May of 2020 to avoid the springing maturity clause in the new term loan agreement. In either case, while the infusion would not have resolved the company’s long-term debt situation, it would have made a noticeable difference in a situation where every available dollar represents progress.

The modifications to the terms, both for the joint venture and the preferred stock transaction, is reportedly associated with challenges related to the transfer funds outside China, especially given the current trade conflict between China and the United States. However, while we can’t particularly fault the company for having a sense of urgency in closing the preferred stock transaction, especially in light of the quickly approaching maturity of the legacy term loan (B-1), it’s nonetheless noteworthy that GNC was willing to surrender substantial value in order to finalize the joint venture and preferred stock transactions. The original terms may have indeed been too sweet, the political situation impossible, and the resulting modified terms the only functional outcome, but the move could also be interpreted by some as representing a degree of desperation in the face of lackluster third quarter operating results.

Regardless of the rationale, the change in the joint venture terms is disappointing from an investor standpoint.

Joint Venture Financial Impact

However, the terms of the joint venture being essentially finalized, the question becomes one of what impact the conversion of the China business to a joint venture structure with a minority equity interest will have on the company’s financial results.

The projection of these results, we should note, are inherently uncertain, and the presentation below represents our initial sketch of the impact as we begin to think about how to reflect these coming modifications more fully in our models for the company. The outcomes create the framework from which we will further refine our projections as additional information becomes available from the company and we perform additional rationality and sensitivity analysis. We also outline our initial assumptions and expectations and the rationale behind those for consideration by readers as well as to allow readers to make their own projections based on differing views on various factors.

We began our analysis by assessing the economics of the company’s existing China business. GNC does not provide a great deal of detail about the China business in its financial reports. The China business is typically either combined with the company’s international operations (primarily international franchise revenues) or with the company’s small Irish store operations for financial reporting purposes. However, it’s possible to interpret the available information and develop a reasonably realistic view of the financials associated with China and this forms the starting point of our assessment.

First, the financial statements allow us to estimate that China revenues for the current year will, at most, be approximately $50 million based on the company’s international revenue presentation. The $50 million revenue figure may slightly overstate actual revenues in China since we can’t exactly determine the revenues associated with company’s Irish stores (which are lumped together with the China business), but the Irish stores probably don’t make a significant difference. Regardless, since this would represent a slight overestimate, we can consider $50 million in China revenues the best case scenario.

Second, we know from the company’s operating income analysis that the operating margin associated with the China business is less than that of the international franchise business. The combined operating margin of the international segment being around 34%, and international franchise sales representing around 75% of total international revenues, we can reasonably calculate that China specific operating margins are likely 28% or less since any higher value would result in international franchise operating margins being essentially identical to those in China. In this case, a 100 basis point change in the operating margin would not make a material difference to the outcomes anyhow, so while we don’t know the exact operating margins, this estimate again provides a best case scenario.

We can thus calculate the operating income and, assuming application of the statutory tax rate of 25% applied to joint ventures in China, a rough estimate of the earnings per share contribution to the company, as reflected in the following table:

Source: Winter Harbor Capital

The China business thus contributes, using the highest possible values, $14.3 million to the company’s operating income, or 7% of the company’s normalized operating income for 2017 of $197.4 million. In the event the operating margin associated with the international franchise business is slightly higher at 38%, the China business operating margin can’t be higher than 22%, resulting in operating income of $11.2 million, or 5.6% of operating income.

However, given that we are at the upper end of the potential range of values for revenues and operating margins, it’s quite possible that the actual contribution to total operating income could be less than 5%. In any case, the inevitable conclusion is that the China business, while not insignificant, is nonetheless a small portion of the company’s operations. Indeed, this is precisely why we have consistently stated in prior articles that the China business in and of itself is unlikely to make a material difference to GNC’s long-term debt situation.

The impact on the company’s financials upon conclusion of the joint venture can thus be estimated by simply accounting for the China business as an equity investment with the company’s equity interest at 35%.

Source: Winter Harbor Capital

The closing of the joint venture would thus reduce the company’s operating income up to $14.3 million (probably less) and the company would instead recognize equity in income from the joint venture of around $3.8 million. The impact to earnings per share – on a very rough basis – would be a reduction of around $0.06 at the upper end of the range.

The impact on the company’s operating cash flows, however, could be more significant and more concerning, especially if the joint venture does not distribute any earnings. Operating cash flows would likely decrease by an amount roughly equal to the operating income (capital expenditures and depreciation in the international segment are rather minimal), with a corresponding impact on free cash flows. The loss of $10 million to $14 million in free cash flows (relative to our projections of annual free cash flows of $80 million to $90 million) would not be insignificant. However, since this would represent the high end of the potential decline in cash flows, the actual impact could be materially less.

The above, of course, is a static analysis of the joint venture impact as if the 65% interest in the existing China business were simply sold to Harbin. However, this is not what will actually occur and therefore simply establishes a foundational reference.

Instead, the accounting treatment of the company’s China operations will switch from being entirely reflected within revenues and expenses in the company’s income statement to a combination of wholesale sales to the joint venture (accounted for in the company’s financial statements) and an allocation of the net earnings or losses of the joint venture based on the company’s equity interest.

GNC has not commented on expectations for the joint venture in terms of revenues or profitability in regular conference calls so developing a projection requires a greater degree of conjecture when dividing the business between the joint venture and the wholesale component. However, we do have a few data points from which to begin constructing a framework.

First, in the third quarter conference call, Ken Martindale, GNC’s chief executive officer, stated that the company believes joint venture revenue could grow to $200 million within three years. The company has confirmed that this revenue projection is based on the preliminary joint venture business plan and, for the time being, have used this revenue benchmark for our revenue projections.

Second, in a call with the company, the company stated that the wholesale mark-up associated with the China joint venture will be lower than that applicable to the international segment and more in line with the domestic company operated store base. In addition, the company expects the joint venture will incur significant marketing expenses in the initial years which will impact joint venture operating margins. We’ve therefore taken these factors into account in developing our projections.

Third, we started with the assumption that the combined operating income of the joint venture and associated wholesale operations regardless of attribution, before any additional marketing expenses, would probably not initially exceed the operating income of the existing China business. In the event we use the manufacturing segment’s operating margin for the wholesale component (based on an assumption of the wholesale pricing relative to the retail pricing), the maximum operating margin possible within with the joint venture while conforming to this restriction is around 23% to 24%. We therefore established a 23% operating margin as the terminal operating margin.

Fourth, it was necessary to establish a preliminary retail gross margin for the joint venture to define the percentage of joint venture retail revenues which would translate into wholesale revenues for the company on the sale of products to the joint venture. GNC's financial statements don't provide much detail with respect to the gross margins of various business, so we attempted a rough estimate by focusing on the relationship between the proportion of the company's domestic store sales represented by proprietary products and the corresponding intersegment eliminations in the company's manufacturing and wholesale segment. Our initial calculations suggest that wholesale revenues represent, at most, approximately 30% of retail revenues, and therefore defined 30% as the best case condition in calculating wholesale revenues.

The resulting projections are reflected in the following table:

Source: Winter Harbor Capital

In this presentation, it’s clear that the joint venture will impact GNC’s operating results and earnings per share in the initial years. The decline in earnings per share in the first year is identical to that projected in the earlier simplified presentation, dissipating to roughly or just under breakeven in the second year and generating additional earnings per share in the third year and beyond. The company’s operating cash flows, however, would be impacted for approximately three years barring any earnings distributions from the joint venture.

We also tested the reasonableness of this outcome based on the distribution of operating income amongst the joint venture partners as reflected in the following table:

Source: Winter Harbor Capital

We’re not especially convinced that GNC, as the 35% partner, will actually capture quite this large a share of total operating income even with the wholesale component. However, it’s not an entirely unreasonable outcome, so our current view is that these projections represent an upper end case both in terms of revenue results in the joint venture and the benefit to GNC from the joint venture and wholesale sales.

We also looked at the joint venture revenues as a whole based on the company’s statement that operating results would be more broadly similar to those of the domestic company owned retail store segment. The results of this simplified analysis are presented below:

Source: Winter Harbor Capital

These results are actually quite similar to the results of the joint venture and wholesale projections above until they begin to diverge in the later years and, even then, by only a few cents per share. The result gives us an added measure of confidence in the initial projections associated with the initial years of the joint venture with added uncertainty in the later years.

In either case, the company’s operating cash flows will decline noticeably which is an unwelcome result of the joint venture in light of the company’s debt load and the modified terms which eliminated the $22 million cash payment to the company.

So, what are our conclusions based on these projections?

First, more work is required to refine these projections as the company provides additional details in the future. The level of uncertainty regarding revenues and operating margins is substantial and will affect the calculated outcomes, perhaps in significant ways.

Second, while the China business may ultimately prove meaningful for the company, the initial result will be lower operating income, operating cash flows, and earnings per share for the company. The joint venture is, in some sense, a gamble on Harbin’s ability to leverage its presence in the market to address challenges regarding the Blue Hat regulations and quickly expand the business. In either case, with the current convertible notes and term loans all essentially due within the next two years, the China business won’t materially change the company’s present financial trajectory. Indeed, when refinancing of the convertible debt and newer term loan occurs, probably in late 2020, the China joint venture may not be generating sufficient revenues, cash flows, or earnings to materially change the refinancing terms available to the company. The project will still be, in some sense, a work in progress.

Third, revenues will likely be the key. The projected revenue growth included in our initial projection averaging 50% per annum is quite high and, while comparable to early growth experiences of similar companies in the China market, represents a significant acceleration from the company’s recent experience. In regard to revenues, we don’t have a specific view on the reasonableness of the company’s revenue goal of $200 million in three years. It’s impossible to say how results will trend until there is some firm evidence on which to base an assessment. In addition, while on the one hand the joint venture business plan has been developed in partnership with a company deeply immersed in the Chinese market, the company’s poor historical performance in projecting other (and, frankly, much more straightforward) results leaves cause for caution.

Fourth, even if our estimates are inaccurate with respect to the percentage of joint venture retail revenues which will translate into wholesale revenues or even the gross margins for either the joint venture or wholesale business, these differences are unlikely to significantly impact the outcome. Indeed, our sensitivity analysis around these values suggests that the resulting change in equivalent earnings per share would be measured in pennies rather than dimes, so our projections appear to be within the ballpark even if not quite at home plate. This is especially true since, as noted before, our calculations use what we estimate to be the best case values for each so that the risk of error is likely to the downside rather than the upside.

Conclusion

The China joint venture represents a potentially substantial opportunity for GNC in the long term but also presents a number of financial challenges in the short term. The incremental loss of earnings and cash flows would be unwelcome due to the company’s significant – and expensive – debt load. In essence, while the China joint venture is probably necessary for the future success of that business, the joint venture alone will not put GNC firmly on a path towards recovery.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

We are effectively long through short put option positions of various expirations and strike prices.