We recommend shorting NUTR. Price target $9.00/ share.
Nutraceutical International Corporation, ("NUTR" or the "Company"), headquartered in Park City, Utah, is a manufacturer, marketer, distributor and retailer of branded nutritional supplements and other natural products that are sold through domestic health food and natural food stores. NUTR currently sells over 6,000 SKUs domestically and over 700 SKUs internationally. NUTR was formed by Bain Capital in 1993 to roll-up smaller firms within its fragmented industry. The investment was highly successful for Bain Capital and over a 10 year period they generated a return in excess of 12x their initial investment likely fueling some of the gains that ballooned Mitt Romney’s IRA account. At the time of its initial public offering in 1998, NUTR was valued at 10x its trailing EBITDA multiple. Unfortunately for investors, NUTR has been a very poor performer and trades at a price lower than its initial public offering price. Total shareholder returns from NUTR dramatically underperformed the Russell 2000 on any long-term basis.
We believe that the issues holding back the stock performance at NUTR are destroying shareholder value and are not fixable. NUTR operates in a highly fragmented industry and has become a mid-tier player through the execution of an active acquisition strategy. This strategy has masked the underlying fast decline of NUTR’s core business which we believe has been shrinking for a number of years. Management would not take repeated requests from us to talk about the issues and provide a plausible explanation for how ROIC might be able to increase. Going forward, NUTR must continue acquiring firms if it wants to continue to mislead the market about the health of its business. Unfortunately, the continued acquisition program has saddled NUTR with a wide array of weak brands that are not compelling and suck a tremendous amount of working capital to support. We used to believe that the wide variety of brands and distribution to 10,000+ retail doors would make NUTR and attractive acquisition target, however, as we have studied the declining results at NUTR and had more conversations with industry experts we believe this is increasing unlikely.
For a long time, people have pointed to the strong industry growth within the vitamins, minerals, and herbal supplements industry (“VMS”) noting that overall the industry appears to have been growing above 6% per annum. However, much of the growth is from new “hit” products which are difficult to predict and further are not the focus of NUTR. We believe that when you strip out such “hit” products industry growth may be 1% to 3% max. Further masking the growth prospects for the industry, were growth in retail doors which for years provided a strong tailwind.
The weak financial performance of NUTR has been masked by frequent acquisitions. We analyzed the financial results of NUTR over the last nine years and noted a number of issues that need to be addressed. The table below compares the trailing twelve month results at of 12/31/11 to the initial year we analyzed 9/30/03:
Net sales $124.5 $189.5
Gross margin 51.5% 50.1%
EBITDA $25.2 $32.8
EBITDA margin 20.2% 17.3%
ROIC 21.1% 10.4%
We noted that over this period revenue had grown nicely, but ROIC had slumped rather dramatically. Further, if the goodwill write-off that occurred in 2008 and 2009 is reversed which would even further increase the capital base, the ROIC for the TTM ended 12/31/11 be well below 10%. This decline in ROIC is troubling given that they are producing returns only barely in excess of their WACC which we calculated to be slightly under 9%. The reason that the ROIC is dropping is that lots of capital has been spent on acquisitions and capital expenditures which combined with the base business have not generated satisfactory returns.
Over the last nine years, approximately $102 million has been spent on acquisitions. To make the analysis as favorable to management as possible, we’ll subtract off the deals that were done in 2003 since we are not sure of the financial impact they had on the 2003 results. That leaves $87.6 million of acquisitions which helped to increase the revenue from $124.5 million to $189.5 million and over the same time horizon EBITDA grew from $25.2 million to $32.8 million.
Based on management’s assertion that it targets acquisitions at 5.0x EBITDA, the $87.6 million should have produced at least $17.5 million of incremental EBITDA, however, we can see that EBITDA only grew $7.6 million. In fact, if the industry grew at only 2% over the last 9 years, we would have expected to see just over $5 million of incremental EBITDA from growth alone and should have gotten the incremental $17.5 million of acquisition EBITDA on top of the normal growth in EBITDA. Based on our knowledge of the industry growth and the acquisitions made by NUTR, EBITDA on a TTM basis should be closer to $48 million annually vs. the current TTM EBITDA of $32.8 million.
In addition to lower than expected earnings from acquisitions, capital spending has also been high. NUTR has expended roughly $93 million on capital expenditures over the last nine years. As we analyzed capital spending as a percentage of sales, capital expenditures have grown from roughly 3% of sales to 7% of sales, and during fiscal 2008 exceeded 10% of sales. While the capital expenditures seems to be focused on making NUTR more efficient, there is no noticeable positive impact in either gross margins or EBITDA margins. Competitor NBTY which was taken private by Carlyle had capital spending equal to roughly 2.0% of annual sales. NUTR has been investing in its capital spending at a rate more than three times higher without generating higher profitability.
As we often find in situations where ROIC is not utilized to assess value creation, ROIC has been falling, and it appears that the compensation plan at NUTR maybe partially to blame for incentivizing such behavior. NUTR discontinued the use of equity grants to incentivize its employees years ago. The compensation plan currently consists of base salaries and cash bonuses. The cash bonuses are all paid based on growth of EBITDA with no apparent focus on the amount of capital employed to generate EBITDA growth. ISS came out against the pay practices at NUTR this year recommending shareholders vote against the compensation plan (23% voted against the compensation plan). Pay has steadily increased at NUTR while ROIC has steadily declined. This is due to the fact that the management of NUTR has been focused on growing EBITDA at any cost which is precisely the behavior one would expect based on the current poorly constructed compensation plan.
Other issues on the horizon - The VMS market is highly dependent upon consumer perception regarding the efficacy and safety of products. Unfortunately, this is an industry wide issue where the actions of other participants can dramatically impact the overall industry and the public’s perceptions. Further products can also be dramatically impacted by scientific research and national media attention focused on products within the VMS industry. Sometimes these impacts can be quite positive and other times they can have a negative impact. In addition, the costs associated with producing, marketing and distributing products are highly dependent on the overall regulatory framework. Any negative developments that increase costs on manufacturers and distributors may decrease NUTR’s profitability and could lead to certain products being removed from the marketplace thereby reducing overall sales.
From a valuation perspective, NUTR looks cheap on the surface, but we think the business is in fairly steep decline and years of acquisitions and capital spending have done nothing to improve its performance. Further, the management team appears weak and is incentivized to take the wrong actions. It is our suspicion that they will be reluctant to make any changes and will ultimately ride this into the ground. Very quickly ROIC will not exceed WACC. We think it is unlikely that any industry player would buy NUTR given its weak collection of brands that are in decline. Further, if you go to many of the retail doors that NUTR has products in, you’ll quickly notice they are smaller health food stores which have been in decline as national chains such as Whole Foods have gained nationwide prominence. We believe a fair price target here is $9.00 per share tops we get this from a five year DCF and EBITDA declining back into low $20 million range over that period. Further as EBITDA declines, we think there are likely inventory write-downs from obsolete goods.
1. Mismanagement driven by flawed compensation plan.
2. Further acquisitions continue to destroy value.
3. Small mom and pop health food stores (NUTR core customer base) continue to underperform industry growth estimates.
4. Capital spending continues at high rate with no noticeable impact on profits.
5. ROIC declines below WACC and never recovers - from core business decline and capex overspending