Description
"Okay. Let me say, I'm a long-term thinker. And so when we do these conference calls and the whole world is looking at quarter to quarter... My philosophy has never been really -- like with an acquisition I am not going to say, 'Okay I don't want to do it because it is going to hurt the next quarter or two quarters or three quarters.' I want to know where we are going to be two or three years from today. I look at the acquisition of Leiner, where it's going to position the Company in the long term as the strongest player in the supplement business here, both in the United States and help us worldwide."
- Scott Rudolph, NTY Chairman and CEO
NTY is world's the largest manufacturer of vitamins and supplements, generating 2.78 billion in LTM sales and nearly 250 million in LTM cash earnings. The company is not particularly well-liked by the Street because management doesn't play the earnings guidance/smoothing game. As a result, the stock is prone to blow-ups on 'missed' quarterly results, even though long-run value has been compounding admirably. The most recent blow-up occurred on April 27th, when NTY fell 20%+ intraday on botched fiscal 2Q10 numbers (fiscal year ending September 30).
The funny thing is, management could have easily 'made' the numbers. Both sales and gross profits were above expectations. SG&A expense was reasonable. This left one (largely controllable) line-item on the cost side above EBIT: advertising expense. But after noticing an abnormally positive response to incremental ad dollars spent late in the quarter, management decided to hike advertising expense by 63% year-over-year. As a result, advertising as a percentage of sales went from 5.5% to 7.2%, and margins came in lower than expected. And although sales of the associated products subsequently went through the roof (and competitors' sales went down), there was no mercy in the stock price reaction.
I think that NTY is a better business than it's generally given credit for. Consider the following points:
- The company is big, vertically-integrated, and well-diversified by product line and distribution channel. Vitamins and supplements are generally repeat-purchase products; NTY does not participate in the faddish weight-loss category. In total, NTY offers 25,000+ SKUs. It produces both its own brands as well as private-label products for all of the major retailers in the US. It has 5.7 million square feet of manufacturing space and capacity for 63 billion tablets a year. It is the largest buyer of raw materials in the industry, spending nearly 600 million on vitamins, minerals, etc., sourced from a diversified base of suppliers.
- The company has generated an average return on tangible capital of greater than 15% over the last 15 years. On an LTM basis, ROIC was greater than 20%. Moreover, the company has grown significantly over time. In fiscal 1996-1997, sales averaged 150 million and EBITDA averaged 50 million. In fiscal 2009-LTM, sales averaged 2.7 billion and EBITDA averaged 400 million. That works out to a CAGR of 25% in sales and 17% in EBITDA. Over the same time period, EBITDA margins have fluctuated between 11.7% and 18.5%, averaging 15%. EBIT margins have fluctuated between 8.4% and 13.9%, averaging 12%. Profitability has generally been very consistent, and the balance sheet is strong with net debt of 226 million compared to equity of 1.25 billion. Moreover, NTY has bought back nearly 10% of its float over the last few years; diluted shares outstanding have fallen from 69 to 63 million.
- NTY has been in business since 1971. The company was originally founded by Arthur Rudolph, and has been run by his son, Scott, since 1993. Scott owns 8% of total shares outstanding, worth more than 200 million. The company's President and CFO, Harvey Kamil, has been with NTY since 1982 and owns 40 million worth of stock. To be fair, insider ownership was higher 10 years ago (closer to 25%), so both Rudolph and Kamil have been selling over time. That being said, Rudolph is in his 50s, and Kamil in his 60s. Moreover, Rudolph gave perhaps the most candid reason for filing a 10b5-1 plan three years ago: "...my wife said she wanted to spend some money. I've been at the company for over 28 years, and so, I filed a 10b5-1 plan in August of 2007... and by the way, my wife is still happy now because she can spend some money."
More Business Background
NTY's business is split into four divisions, of which the largest - wholesale - accounts for 62% of overall sales and 60% of overall EBIT (before corporate expense, based on the most recent half-year figures). This 1.6 billion division produces both branded (62%) and private-label (38%) product for all of the major retailers in the US. The branded business includes names such as Nature's Bounty, Ester-C, Solgar, MET-Rx, Osteo Bi-Flex, Sundown, Rexall, and Pure Protein, among others, covering the low, mid, and high ends of the market. The private-label business is by far the largest in the space. The branded business generates higher gross margins (roughly 40-50%) than private-label (roughly 15-20%).
Overall wholesale gross margins are in the low 30s, w/EBIT margins in the low teens. As a further illustration of the company's ubiquity in this channel, consider that NTY serves as the category captain/validator for 20 of the 25 largest retailers in the country, including Wal-Mart, Costco, CVS, Target, and K-Mart.
Wholesale is also by far the fastest growing of the four divisions, having increased sales from 300 million in late 2002 to more than 1.6 billion today. A large part of this growth, however, has been via acquisition. Industry-wide organic growth is difficult to pin down - management points to positive demographic trends (i.e. more baby boomers retiring, needing more vitamins and supplements) as a catalyst for the recently explosive top-line results (wholesale revenue up 19% year-on-year over the last two quarters, overall revenue up 16%). I'm more inclined to believe that it's just a hot streak. If you look at the history of the industry, there are ebbs and flows. In the mid-90s, there was a period of significantly increased demand with the 'discovery' of Eastern herbs, but then growth slowed in the early 2000s. More recently, growth has ramped up again. All the while, the population is getting older, but not nearly quickly enough to explain the dramatic changes. I think that a fair long-term expectation is mid-single digit increases in top line for this division.
The company also operates two retail divisions: North American Retail and European Retail. The European division, with 537 stores under the Holland & Barrett banner and another 500 or so under a variety of other brands, is by far the better business. Holland & Barrett has been a leading health food store in the UK since the early part of the 20th century, and has grown significantly from the time the chain was acquired by NTY in 1997. Although EBIT margins have dipped in the last two years (coinciding with the recession), the average margin over the last decade for this segment has exceeded 20%. The European business as a whole accounts for 23% of overall sales and 25% of overall EBIT.
NTY's North American division operates 442 mall-based Vitamin World stores in the US and 86 Le Naturiste stores in Canada. This division has basically never been profitable, operating at breakeven over the last half-decade or so. The reason why management hasn't sold the business is because it provides both operating leverage for the wholesale side and acts as an effective front-end for customer data acquisition (to then be shared with wholesale customers). This doesn't sit well with me, but what could you do. The North American business accounts for 7% of overall sales and 1% of EBIT.
The last of NTY's four divisions is the direct business. The includes sales made via the company's online storefront, PuritanPride.com (50%), and via catalog (50%). EBIT margins for this division over time have remained in the mid-20s while capital expenditures are understandably low, resulting in great returns on capital. Unfortunately, the business is not growing, instead generating annuity like revenues around 200 million a year for the last dozen years or so. The direct division accounts for 8% of overall revenue and 14% of overall EBIT.
Margin Trends and Concerns
As noted above, NTY's operating margins have been very steady over the years. However, the composition of these margins has changed quite a bit. Gross margins have fallen from the mid-50s a decade ago to 45% on an LTM basis as the company's private-label business has expanded (especially with the acquisition of Leiner, a large private-label manufacturer, out of bankruptcy in 2008). But while private-label generates lower gross margins, it also requires lower SG&A and advertising support. As such, SG&A expenses as a percentage of revenues have fallen steadily as well, from nearly 40% of sales in 2001 to less than 28% today. Advertising has fallen from 5-6% of sales to below 5% today.
Therefore, whereas in 2001 NTY generated an 11% EBIT margin based on gross margins of 56%, SG&A expense as a percentage of revenue of 39%, and advertising expense as a percentage of revenue of 6% (56 - 39 - 6 = 11), the company generated that same 11% EBIT margin in 2009 with gross profits at 44%, SG&A at 29%, and advertising at 4%.
2009 was of course a very difficult year, especially as NTY's fiscal '09 included calendar 4Q08. In calendar 4Q08, EBIT margins for the company fell to 6.8%, partly on difficulties integrating the Leiner acquisition (see the conference call transcripts at that time for a more detailed explanation). In calendar 1Q09, EBIT margins rebounded to 7.4%. In 2Q09, margins normalized to 13.2%, before rising to historically peaky levels of 14.9% in 3Q and 16.3% in 4Q09. In the most recent quarter, margins fell back to 11.2%, in part due to the increased advertising spend as discussed at the beginning of this write-up. The LTM figure settles out at 13.9%.
Valuation
For valuation purposes, the question of long-run normalized margin is key. Looking at LTM results alone, NTY is ostensibly trading at 10.4x cash earnings (after adding back 16mm in non-cash amortization), which is a good price for a business that is currently growing the top line at double-digit rates. However, LTM results are likely unsustainable given potential margin pressures in NTY's private-label business.
So what is a sustainable margin? It is worth emphasizing that in no annual period since 1996 have EBIT margins fallen below 8.4%. This trough occurred in 2005, again following acquisition integration difficulties (and when SG&A was still at ~34% of sales). The average EBIT margin since '96 has been 12%.
I actually think that 12% is a pretty reasonable number to use for a conservative base case scenario. This figure assumes gross margins of 44.2% (significantly lower than the LTM result of 45.4%, taking into account private-label pressure), advertising expense as a percentage of sales of 4.7% (per management's guidance), and SG&A expense as a percentage of sales of 27.5% (again higher than the LTM result of 27%). Based on LTM sales of 2.78 billion, a 12% margin results in EBIT of 334 million. After deducting 30 million in interest expense and 35.5% in taxes, and adding back 16 million in non-cash amortization, cash earnings are 212 million. Compared with a current market cap of 2.6 billion, the multiple is 12.3x. While not stunning, an 8% earnings yield isn't bad when combined with strong near-term and reasonable long-term growth, for the largest and lowest-cost player in the industry.
Catalyst
- Return to normalized marketing spend.
- Easing of fears over a few bad quarters as long-term value continues to compound.