Description

GNC HOLDINGS, INC.

Company:  GNC Holdings, Inc.

Security:  Bank debt: B2 Term Loan due 03/2021, L+875bps (“TL”)

Bank Debt Price / Yield: 97c / ~13% yield-to-maturity

Recommendation: Long

Executive Summary/Summary Thesis

The prevailing price/yield of the TL suggests that the market is concerned about GNC’s ability to repay or refinance the bank debt at maturity in March 2021. My assumptions are less draconian than the market’s as I believe the company has ample tools to address its maturity schedule that will ultimately result in an attractive absolute return for the TL holders. Management has retained advisors and is proactively engaged with its equity sponsor and the lenders to evaluate liability management options. In the meantime, investors are creating the company at 2019e ~3.1x Adj. EBITDA/~3.4x UFCF and getting paid 11% current yield with the prospect of 13% YTM assuming a paydown/refi at maturity. Based on recent news, however, there is a legitimate scenario of a buyout and/or refinancing prior to maturity that would result in a higher annualized absolute return given the 101 change of control premium or 102 current call price.

Core thesis: Operational restructuring + Supportive Sponsor + Refinancing/Buyout Catalyst + Attractive Valuation/Yield + Solid Covenants + Strong Liquidity

·         Operational restructuring – the company offers products that remain “on trend” towards a healthy lifestyle and management is squarely focused on addressing its outdated distribution model, essentially closing stores (and recouping 30% of revenue at nearby locations) and cutting costs; the company has too many stores and the strategy is now geared towards reducing the footprint, expanding margins and harvesting cash versus driving store growth, and results have begun to stabilize with higher operating margins, online sales in process of inflecting and positive free cash flow YTD.

·         Supportive sponsor – Government-backed Harbin Pharmaceutical Group (a pharma and VMS company based in China) invested $300MM in a convertible preferred (subordinate to the bank debt) in 2018/19 and now effectively owns 40% of the company on an as-converted basis with a right to designate five of the 11 board members. This has enabled the company to delever its debt profile from 5x two years ago to below 3.5x (on a net basis). There is also potentially a significant opportunity in China where GNC has formed a JV to leverage Harbin’s distribution and manufacturing network in the 2nd largest VMS market.

·         Refinancing / buyout catalyst – the company is working with advisors on and an ad hoc group of TL holders to address its capital structure. A recent Bloomberg article provides specific details of a potential refinancing and go-private transaction suggesting that discussions with Harbin are ‘real’.

·         Attractive valuation / yield - healthy yield (13%), short duration (matures in 18 months), cheap creation multiple (at 3.1x) relative to its sum-of-parts valuation (implied 25% subordination – see Valuation below) and GNC’s main competitor, Vitamin Shoppe (VSI), which is going private at a ~3.5x valuation. VSI is about half the size of GNC in revenue terms and generates lower Adj. EBITDA margins (6.4% vs 9.2% for GNC).

·         Solid covenants – The TL credit agreement has a springing maturity ahead of the converts and also contains maintenance covenant protection.

·         Good liquidity profile – the combination of a recent asset sale, working capital improvements, free cash flow generation and revolver availability has put GNC in a good liquidity position (~$190MM) to address its maturity schedule.

Risks / Overhangs:

·         Changing industry dynamics – While the industry backdrop is positive from a secular growth perspective, the marketing and distribution paradigm has shifted. Two key trends have led to poor performance in recent years: 1) a structural shift from brick-and-mortar to online – VMS products are logistically light items generally designed as part of a replenishment program and therefore ideally suited to online shopping/fulfilment; and 2) competition has intensified – mass-market retailers, such as Kroger, Wholefoods and WalMart, have entered the market with lower priced 3rd party products and a focus on appealing to the price conscientious ‘older’ demographic. As a result, same store sales have declined steadily for the last two years. In Q2-19, the company reported its softest quarterly comp (-4.6%) in 2 years but rebounded somewhat in Q3 to -2.8% largely due to the ramp in online sales. It has also become apparent that the company has too many stores which resulted in cannibalization.

·         Refinancing / buyout risk – the refinancing/buyout deal could certainly fail or get delayed given the requirement for a CFIUS review as Harbin is a Chinese-domiciled entity essentially owned by the government. While the TL has some covenant protection, the converts are still technically ‘time senior’ to the bank debt and may have holdout leverage in the refinancing efforts, especially given the company’s current liquidity position.

What do we know: The Basics

Capital Structure

Company Description

GNC is a pure-play retailer in the vitamins, minerals and supplements (VMS) space. The company has been around for +80 years and has 7,779 locations worldwide made up of 2,999 company-owned (in the US and Canada), 987 domestic franchise, 1,921 international (mostly franchise) stores and 1,872 stores-within-a-store (agreement with Rite Aid). At a top line level, ~95% of revenue is generated in the US.

GNC sells both proprietary and 3rd party-branded products focused on health, wellness and performance. The company’s key attributes include:

·         Proprietary products and brand awareness - GNC develops and distributes proprietary products that can only be sourced through select channels (the company’s own store locations, GNC.com, Amazon and predetermined wholesale partners). Currently 51% of revenue comes from proprietary products (vs 44% in 2017) and 49% from 3rd party. Proprietary products naturally carry a higher margin than 3rd party. The company also claims to have significant brand awareness:

Clearly anyone who claims to have greater brand awareness than Amazon lacks credibility in my view but perhaps this survey is skewed to the +40yrs demographic and international geographies. Having said that even if brand recognition is 2/3rds of what the survey suggests, that would put GNC in the 50-55% context, and in the same vicinity as Costco, Wholefoods and Target.

·         Loyalty program – the company has a developed a large and deep database of loyal customers which should help GNC better understand customers’ buying patterns, behaviors and needs. Sophisticated data should lead to ‘hyper-personalization’ where customers are willing to exchange personal data for superior outcomes. GNC now has ~17MM loyalty members, compared to 11.4MM in 2017 (49% increase), which includes 1MM PRO Access members that pay $39.99/annum. The company rolled out a subscription program a few years ago which has grown from 30k customers in 2017 to 285k currently, and projected to increase to 500k in 2020e.

·         Omni-channel development focused on ramping online – given the structural shift to online the company is implementing strategies to blend digital and in-store platforms which should also serve to reinforce brand and product awareness. The comprehensive channel strategy should help increase customer engagement particularly among customers that actively solicit guidance on health and wellness. E-commerce sales have increased 140bps from 7.2% of US and Canada revenue in Q3-18 to 8.6% in the most recent quarter. The Company’s goal is to increase E-commerce to 15% over time which would add $160MM in incremental revenue.

·         Harbin Pharma / China opportunity – in 2018, Harbin agreed to invest $300MM in GNC and enter into definitive JV partnerships in Hong Kong and China. The partnership enables GNC to leverage Harbin’s extensive distribution, sales and marketing infrastructure to expand in China, the 2nd largest vitamin and nutrition supplement market. The VMS market in China is currently ~$25BN in sales and expected to grow 9.1% per annum over the next five years. Given Harbin’s investment in GNC and 65% ownership stake in the China and HK JVs, incentives appear aligned.

·         International growth – the company currently operates in over 50 countries outside North America where international franchisees account for ~70% of international segment revenue. The segment has shown steady growth in recent years and the company is focused on developing partnerships in new regions. Globally the market is expected to grow 6.2% per annum over the next five years. 

Optically, sales of the international segment have declined in the last nine months ($117MM revenue YTD-19 vs $140MM YTD-18) largely due to moving China-domiciled assets to the JVs with Harbin.

·         Operational restructuring – recognizing the secular changes in the distribution and competitive landscape (albeit a little late), in 2018 management rolled out a store optimization plan which identified 700 to 900 corporate stores in the US and Canada to be closed within three years at the end of the current lease terms. 

Recent Operating Performance:

·         Financial summary

·         Key Performance Indicators / Comp Sales

While the company continues to experience challenges on revenues and domestic retail same-store sales, operating margins have improved, online comp sales seem to be inflecting and the company still generates healthy free cash flow.

What can we infer: why is it mispriced? The key areas of debate include:

1)      Operational restructuring:

Given the structural shift to online and overcrowding of company-owned stores in the US and Canada (it is estimated that 92-95% of the store population is within 1 mile), management has rolled out a plan to close 700 to 900 company-owned stores by the end of 2021 and has already closed ~400 stores (~13% of the footprint) in the last 5 quarters:

·         US and Canada - Operating Margins: Operating Income was up for the third consecutive quarter year-on-year in 2019. In Q3-19, Operating Income margins were 7.3%, up 190bps from 5.4% in Q3-18 driven by store closures, stronger product margins and reduced costs. The company is seeing a transfer of more than 30% of sales of closed locations to nearby stores which is clearly improving store occupancy and a driver of incremental margin. From a same-store sales perspective, company-owned stores see a 1-point improvement from store closures while domestic franchise stores see a 2-point improvement given the smaller base of franchise stores benefiting from the same number of closures, hence the difference in comp sales performance in Q3-19 (-2.8% for company-owned stores vs -0.8% for domestic franchise).

·         Cost Savings / Working Capital – the company is progressing ahead of its $29MM cost reduction target for 2019 and on pace to exceed $50MM annualized cost savings by 2020. On the working capital front the company has generated ~$20MM YTD largely due to a large increase in accounts payables over the year presumably due to the sale of the manufacturing business. The company has generated solid free cash flow YTD: ~$67MM in CFFO less capex (pre-working capital) and ~$87MM including working capital.

·         Online/E-commerce – after declining every quarter for the last five quarters through Q2-19, even posting a negative comp in that quarter, online SSS rebounded in Q3-19 with a +1.6% comp – while I think it is too early to tell management appears convinced that e-commerce has inflected and “now turned a corner”. E-commerce now contributes 8.6% of US and Canada sales vs 7.2% a year ago.

·         Transformation to ‘mini-warehouse’ – the company plans to roll out a mobile in-store POS in 2020 that will make it possible for customers to buy products and pick them in the store or have what they need shipped from a GNC store directly to their home. This is an important step as the GNC store can be both customer-facing and a mini-fulfilment center which will serve to improve local customer engagement and level the logistical competitive landscape with the larger online marketplaces.  

2)      Supportive sponsor:

·         Given the recent timeframe of its $300MM investment, Harbin was presumably aware of GNC’s turnaround prospects and debt maturity schedule, and should be adequately prepared for the recent refinancing discussions.   

·         The investment has already enabled the company to delever its balance sheet and approach the negotiation with the converts/TL from a position of ‘strength’ as opposed to handing over the keys.

·         Harbin’s preferred is structured as subordinate to the secured debt and designed to take an active role in the company’s strategic direction as opposed to priming the TL or having an embedded ‘put’ option to the company before the TL matures.

3)  Refinancing / buyout catalyst:

·         On the Q3-19 call, management said they were talking to US investors, Asian investors, credit holders and equity holders, and are targeting to announce a resolution in Q4-19.

·         A recent Bloomberg article provided specific details on the refi process: GNC is seeking up to $880MM, and China Merchants Bank and HSBC are arranging the facility. The proposed 5-year facility will be split into multiple tranches with a portion directly recourse to Harbin and proceeds earmarked to pay down the converts, TL and FILO.

·         The refinancing is presumably in the context of a broader Harbin buyout which will require CFIUS approval. Harbin’s $300MM investment in 2018/19 also required CFIUS review.

4)      Attractive valuation: 

I view the assumptions as generally fair to conservative, particularly in the context of the VSI acquisition (higher multiple than where the TL is currently trading and lower quality business) and believe there is sufficient subordination behind the TL.

5)  Solid Covenant Protection

·         The TL has a springing maturity date of May 2020 if more than $50MM of the $150MM Convertible Notes remain outstanding at that date.

·         The net first lien leverage maintenance coverage ratio drops 4.25x on 12/31/19 from 5x currently, limiting management’s ability to raise incremental pari passu debt.

·         Call protection of 102 steps down to 101 in February 2020. There is an additional make-whole payment through March 2021 if call protection is triggered by bankruptcy.

·         Worth noting that the FILO has a 1st lien on the inventory and A/R – there is $275MM FILO outstanding vs $395MM inventory and ~$111MM A/R.

·         The TL has 1st lien on all collateral except the FILO collateral where it has a 2nd lien.

6)      Solid Liquidity Profile

Management has guided to ~$95MM midpoint FCF for 2019, which would add ~$8-10MM to the Q3-19 liquidity profile of $190MM, implying very healthy yearend liquidity of $200MM (~$130MM cash, ~$70MM RCF).

Key Risks and Uncertainties:

1)  Recent revenue and same store sales performance:

·         There is no argument that GNC failed to react to the changing industry dynamics in a timely manner and has been challenged as a result.

·         Handicapping the probability or timing of a turnaround is tough but I would reiterate that I am not particularly positive on the company’s prospects, I am just less pessimistic than the market and would highlight the following mitigants:

o   Improvement in company-owned operating margins

o   Possible inflection in online contribution to comp sales

o   Strong international performance

o   Positive one-time adjustments in working capital

o   Solid free cash flow generation (for now)

o   TL recovery doesn’t require herculean assumptions

o   VSI deal

2)  Refinancing risk:

·         Given the prevailing US-China trade climate, a CFIUS approval process is clearly a risk and also difficult to handicap.

·         I would highlight the following deal characteristics that don’t meet the typical CFIUS red flags :

o   The VMS sector is generally not considered to be an information sensitive industry strewn with highly protected IP

o   The merged entity will not have a dominant market share

o   Harbin has already received CFIUS approval for its initial investment of a 40% stake on an as-converted basis

o   This deal is supportive to the survival and long-term success of a US company with a long history and ~15k employees.

The Catalysts

·         Refinancing / Buyout.

·         Progress on operational restructuring.

Catalyst

·         Refinancing / Buyout.

·         Progress on operational restructuring.