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GNC Investment Rational

|Includes: GNC Holdings, Inc. (GNC)

I enclose my investment rational for GNC for SA feedback.

Summary

  • GNC was a growing profitable business until 2014 when same store sales (SSS) started to decline. Consumers perceived them as overpriced and in store support was not considered a unique value differentiator.
  • Pricing confusion and overpriced perception really started with changes made in May 2013 to the Gold Card loyalty program which generated 80-85% of total retail sales.
  • Simply put, GNC did not give consumers a good enough reason to visit their stores and the CEO from Aug 2014 to Jul 2016 was unwilling to make changes to Gold Card cash cow. The stock price started trending downwards about 12 months ago and Wall Street sell side pounced, taking price down to $6.50 in April 2017.
  • New CEO, 40-year retail veteran and board member at the time of GNC, was brought on as interim CEO in Jul 2016. He introduced a new strategy with 5 focus areas: 1) Improving the retail customer experience 2) Revised pricing 3) New loyalty program 4) Product innovation and 5) Marketing.
  • Q1 Results show the turnaround strategy is working so personal opinion is that short sellers have created one of the greatest buying opportunities.

Introduction

My investment rational is broken up into 5 sections

  1. Understand the business your investing in
  2. Know who runs the business
  3. Invest for profits over time
  4. Have confidence in your own reasoning
  5. Invest with a margin of safety of at least 50%

1) Understand the business your investing in

  • GNC is a leading global specialty retailer of health and wellness (H&W) and performance products with around 9,000 stores globally. Products include primarily vitamins, minerals and herbal supplements products (VMHS), sports nutrition, and diet products.
  • According to Euromonitor, GNC is ranked sixth in the US in 2016 with 2 % "value share," in vitamins and dietary supplements category and 4 % value share in the sports nutrition category, ranking fifth in the category.
  • It is a multi sales channel business: USA based company owned stores (3,500 Q1 2017), Domestic franchise (Rite Aid 2,371 + 1,164 = 3,535) and International franchise (1,949) owned stores, 3rd party contract mfct, e-commerce and corporate partnerships. Most of the company owned stores are in shopping and strip shopping centers.
  • Sales breakdown is as follow: GNC company owned and online (Gnc.com, Amazon Marketplace, and LuckyVitamin.com) retail (74%), Domestic and International Franchise (17%), Mfct and W/S (9%) of proprietary and 3rd party brands like Rite Aid, Sams Club, Petsmart and drugstore.com.
  • Segment sales breakdown as per financial statements are as follow: US and Canada (84%), International (7%), Mfct and W/S (9%).

2) Know who runs the business (Warren Buffett: Buying into retail with bad management is like buying the Eifel Tower without an elevator)

  • Joe Fortunato, was CEO and at time of 2011 NYSE listing until Aug 2014. He was known for raising prices and infamously in July 2013 gave 3mm one year Gold Card member passes for free vs. charging the $15 annual fee realizing the power of the loyalty program.
  • Next CEO, Mike Archbold, from Aug '14 to Jul 16: When he took over, he expressed concerns about the pricing strategy and that the Gold Card program needed an overall following May 2013 changes. However, it appears no changes were made and his focus was to milk the cow for as long as possible.
  • A new interim CEO, Bob Moran, was appointed Jul 2016. He has over four decades as a successful retail executive and demonstrated proven ability to lead organizations in highly competitive environments and deliver profitable growth and shareholder value. Before GNC he was CEO of Petsmart which he turned around and which was eventually sold for $8.7bn on just over $2bn of sales in 2015.
  • Following a 90-day review of business, new CEO described GNC business model as badly broken and in need of change. At the end of 2016, he rolled out a new strategy focused on 5 areas or pillars 1) Retail customer experience 2) Pricing 3) loyalty program 4) Product innovation and 5) Marketing.
  • He tested a new single tier pricing strategy in pilot stores in Sept and Oct 2016. These pilot stores are tracking flat to slightly positive SSS growth through end of Q1. I assume these positive results were a driving force in him buying 593K GNC shares for $5mm on the open market Q1 2017. This represented around 1% of outstanding shares of GNC at the time. Other directors have also bought north of $1mm of shares in Q1 on the open market.
  • Current CFO, Tricia Tolivar has been there since Q1 2015.

3) Invest for profits over time (look at revenue, margins, and earnings growth over last couple of years)

  • Revenue: After 2 straight years of 1% expansion, the company's top line fell 5.3 percent in 2016. Considered the "reset" year as new pricing model was introduced Dec 29th. The CEO closed 4500 stores for 1 day to roll out the new GNC. Despite the bad 2016 results, sales are still 25 % higher than when it listed in 2011 and on track to be > $2.5Bn in 2017 with a 5 Yr. CAGR of 4.2%
  • Gross Margins: Has slowly been going down over last 4 years, reaching a decade-low 33.4 percent for the FY 2016. This is partially driven by price competition and the rise of discount e-commerce. In 2017, GNC is reducing promos which will help get GP margin back to 34%. I would be surprised if GP goes above prior 5-year avg. of 35% given increasing competition.
  • Earnings and Operating Margins: GNC's operating margin and net margin also experienced a strong period leading up to 2012, at which point they stagnated and began to decline. Even after adjusting for a large non-cash impairment charge in 2016, the downward trend in margins continued.

Key Take-away is that up until 2016, all key financial metrics were slowly deteriorating. Below are some of the factors I believe are present that will ensure future growth over next 5 to 10 years.

a) Company-owned stores transactions during Q1 were vs PY: January up 7.5%; February up 7.8%; and March up 11.7% (mkt push in March) for avg. of 9.3% vs -6.5% in Q4.

b) Overall company owned SSS were down 3.9% vs Wall Street expected 6.5%. Composition of 3.9% = Transaction volume up 9.3%. ("GNC has not seen such a significant increase in many years") offset by basket size down 12%. International SSS were up 3.8% and domestic franchise stores SSS were down 4.6% but transactions up 4.2% offset by lower basket sizes. Also, keep in mind the results from ~500 Sept and October 2016 pilot stores reported for Q1 period and which are 5% pts above rest of chain.

The priority was to get customers back into stores buying GNC products, which they have been able to do, and as per interim CEO, the natural next step is to add to consumers' basket size. Several initiatives have already been rolled out to achieve this.

c) Online sales are down 7% vs 49% in previous quarter and since launch on Amazon Marketplace. Currently this segment only represent around 9% of total sales. Worht noting that Amazon reviews are consistently tracking +93% favorable.

d) Per 10Q, had 5mm registered myGNCreward members end of March 2017, and by earnings release April 18th had additional 400K for total of 5.4mm (as per CEO on call maybe wanting to show that numbers were tracking up significantly). Pro Access membership is already 100K with the real push at end of March. Store visits are way up and averaged 1.5x for Q1 vs 4x per year under old Gold Card. Vitamin Shoppe, one of GNC's only pure play competitors, has almost same number of loyalty members but GNC is 12x larger on physical footprint and 2x their size on revenues. As such, I estimate that sign ups will be close to 8mm post Q2.

e) Marketing initiatives are paying off. The new GNC ad that was banned by NFL is approaching 20 mm social media views and the CFO mentioned they are seeing 3-1 ROI on Q1 marketing and rolling those into Q2.

f) Revenue exceeded analyst expectations by 3%. Total revenue decline was much lower than analysts expected at 3.6% and that is only after 1 quarter following roll out of new strategy. Normally it takes a few more quarters to see whether any revised strategy will work.

g) Better information and CRM system: E-mail registrations are required for signing up to the new loyalty program and this feature will allow them to better tracks buying behavior. As such, I expect lower customer acquisition costs but with similar customer lifetime values. With the help of digital correspondence, basket sizes will slowly start to increase. They have also brought data mining skills in house (previous worked with Dunnhumby) so they are aware the power big data analytics can have on sales.

h) International only represents around 7% of total sales but growing. China, a large untapped market has only around 5 company owned stores on the mainland and HK has 87 franchise stores.

i) Projected 2017 FCF base of $250mm. Achievable with combo if inventory adjustments and increased operating performance. This is also an important milestone for sales teams momentum and for the bond markets. If the stock price can slightly recover to $1bn market cap then debt holders will be much more receptive to restructure the $1bn term loan due MArch 2019.

j) Debt levels: If GNC refranchises all 3500-remaining company owned stores with average proceeds between $300 and $400K, then they will be able to service debt.

4) Have confidence in your own reasoning

What are others saying that are different that your opinion.

a) their debt levels are too high.

Response: GNC should be able to pay off the revolver in 2017 and the convertible is not due for 3 more years. Therefore, the $1.1bn term loan due partially end of 2018 and balance in March 2019 is what needs to get paid or more than likely refinanced. There are two scenarios a) With a broken operating model, 95% of the stores are still CF positive so refranchise all the stores and pay down debt with proceeds or b) keep growing SSS, driving up profit and FCF and the corresponding stock price should continue to rise to around $14 per share or 6-7 estimated P/E. Bond holders will look at market cap and so unless general market conditions worsens and banks refuse to lend like in the recession, improving the SSS will be sufficient to be able to refinance debt by 2019. CFO also said Q1 that no risk of breaking covenants in 2017.

b) There is little value in being a distributor which has great in store experience as online resources far exceed the value you can get from any in store clerk. For example, Bodybuilding.com and Amazon.com provide unlimited amount of research and reviews.

Response: Amazon is great at shipping commodity type products given their size. However, over 50% of GNC products are proprietary. Furthermore, GNC sells consumables. Generally, people want to know what they consume and who wants to spend hours online researching when you can walk into your favorite neighborhood store with a friendly, helpful clerk behind the desk.

c) The revised pricing model won't be sufficient to reverse negative SSS.

Response: GNC's revised pricing did not include a sweeping price reduction across the board to bring customer back at all costs. They carefully and very deliberately decreased price on around 50% of all items, 25% remained same, and 25% were increased. This helped to drive significant increase in transactions.

5) Invest with a margin of safety of at least 50%

  • Doing 10 yr. DCF given new operating model at this stage does not make a lot of sense. However, applying a 10x capitalization rate (50% lower than avg. P/E ratio since 2011 IPO) results in a ~$19-20 price applied to my normalized earnings estimate.
  • Alternatively, taking 2016 adj. EPS of 2.15 and applying a more conservative 8x capitalization rate results in a $17.2 stock price. Both significantly above current $7.50 price and not considering any material improvement in online or international sales or leveraging the Pro Access membership.
  • Revenue multiples: Q1 revenue was $654mm. Generally, Q1 represents around 26% of FY sales and therefore GNC on track to deliver at least $2.5bn in FY sales. Current market cap is $550mm representing Price/Sales Ratio of 0.22. This is significantly lower than peers who trade around between 0.5 and 1. Even assuming P/S of 0.5, results in market cap of $1.25 Bn more than 2x above current cap.

Disclosure: I am/we are long GNC.