Description

Chattem is a small ($93 mn market cap ), niche branded consumer products
company.The company manufactures and markets mostly over-the-counter
healthcare products including: Dexatrim , Gold Bond, Icy Hot ,Flexall ,
Bullfrog sunblock ,Phisoderm and Pamprin.The company was dealt a major blow
in October when the FDA ruled that Phenylpropanolamine (PPA) was unsafe and
Chattem was forced to pull Dexatrim with PPA from the shelves.A new line
Dexatrim Natural was launched without PPA .At the start of this year the
company anticipated that sales of Dexatrim Natural would amount to $15
compared to sales of Dexatrim of $30 before the product recall.
The other major event last year was the sale of their Ban line of
deodorants for $160 mn ( plus $6.5 mn of possible contingency payments ).The
completion of this deal materially improved the financial position of the
company allowing it to pay $52 to close its credit facility , retire $78
million of senior subordinated notes and buy back 400,000 shares in Q4
.Management took all this activity as the opportunity to create a clean
slate for its operating performance in 2001.All in all charges amounted to
$19.3 mn , offset by an extraordinary gain of $8.6 mn on the retirement of
debt that was realised in Q1 '01.
At the start of this year management was forecasting EBITDA of $38-40 and
EPS of 65c.However , this budget was built assuming flat sales for most
brands and the company deliberately low-balled their estimates so as to only
deliver positive surprises .On top of this goodwill amortization was
expected to amount to around 43c , giving cash EPS in excess of $1 per
share.
Coming into the year after all the changes the prospects for 01 depended
largely upon 4 products: Icy Hot , Dexatrim Natural, Pamprin , and Gold
Bond.
Chattem had been forecasting a loss of 4-8c for its first quarter but
produced a positive surprise and made 7c per share before extraordinary
items ( the $8.6 gain referred to earlier ).Sales were up 5% from Q1 '00 on
a pro-froma basis .Importantly Dexatrim Natural surpassed expectations and
Gold Bond sales bounced back from a poor 2000.Sales of Dexatrim Natural look
set to top $20 mn and probably get back to previous levels over the next few
years.On the basis of this I expect Chattem to produce $80-85c in EPS this
year .In the long-run management thinks that the top-line can grow 3-5%
,which should be possible .These products are clearly not "inevitables " but
they are nice branded little niche products .In the short-term topline
growth may temporarily accelerate a little due to product line extensions
.Value Line recently raised its '01 EPS forecast to 80c.
My forecasts for this year are the following :
Net income = $7.1 ( 80c x 8.9 mn shares )
D and A = $10.1
Cap-ex = $2.5 = Free cash flow of $14.75 or $ 1.65 per share .On a
fully diluted basis there are about 9.7 mn shares outstanding . Total
proceeds from the exercise of stock options assuming full dilution should be
around .768 x 12.5 =$9.6 mn .If I assume that they keep this as a cash
equivalent it should add around 0.3 mn to free cash after tax.This will all
produce free cash per share of $1.55 per share .At a stock price of 10.5
this means that CHTT trades at 6.75x free cash flow.Value line assume a much
higher level of cap-ex which has been the case in recent years because of
the building out of a new manufacturing facility and invcstment in new
information systems .The company predicts that over the next 2-3 years
cap-ex should be about $2.5 mn annually , although in the long run
maintenance cap-ex may be closer to $3.5 mn.
In my opinion , now that the dust is settling this is a very cheap stock
( although up quite a way from where I first submitted it to VIC as my
application ).Not only does the 01 multiple look cheap but I expect strong
growth in free cash flows in 02 driven by ;
1 / Top-line growth.This should reach at least 5% driven by new product
launches ( Icy Hot patch ; Phisoderm and Gold Bond product line extensions ;
further gains for Dexatrim Natural ).
2 / Reduced interests costs as they retire the 12.75% debt.
3 / Expansion of margins .Factories are only running at 70% of capacity .Any
volume growth should improve margins , and advertising and promotion spend
as a % of sales should drop back to a more normal 40% from 44% in Q1 and
42.3 in 00.
4 / Buybacks .The company has $6.6 mn available under their authorised share
repurchase scheme .
On the way down in this stock insiders were heavy buyers and officers and
directors own 17% of the company.
Risks;
1 / Debt level.The company is heavily indebted and very leveraged. At the
end of Q1 there was $46 in equity , $ 37 in cash , and long term debt of
$226.In the second half of this year CHTT intends to retire $22 mn of its
expensive 12.75 % notes.Although leverage is high on an ongoing basis EBITDA
- CAPEX coverage is greater than 2.25 x which should be Ok for relatively
stable consumer products .Also their remaining debt will not mature until
2008.Clearly the level of debt is a real issue but IMO they will be fine.
2 / Liability associated with PPA.In the long run I suspect that this will
not be too much of an issue .The company is only liable for sales since 1998
when they acquired the brand and has had a warning for people at risk for
strokes on the package that entire period.They have insurance covering this
liability and lawyer fees associated with a six figure deductible and a nine
figure cap. CHTT has successfully gotten itself removed from 2 out of 3
suits in California.IMO they will be ok but it is clearly a risk.
3 / It is also possible that their Dexatrim Natural brand will be pulled
because of the FDA looking into ephedra the active ingredient.However , the
side-effects of this product are well known and the dosage in Dexatrim so
low that this is a very low probability event .More prominent warnings are
much more likely.
4 / Management making a bad acquisition .This is probably the biggest risk
.Their game plan is to grow by buying under developed brands .Net net it has
worked but there have been some real flops .At this level of prices I would
much rather they bought back stock .

Catalyst

clearer visibility ; positive eps surprises ; successful product
launches and significant free cash generation.