Description

Nutraceutical is a rather unremarkable company (with an unremarkable name) in an unremarkable industry that is trading at a rather remarkable multiple of free cash flow: 8.6 on a trailing basis (defined as operating cash flow minus capex).

BACKGROUND

Nutraceutical (NUTR) was formed in 1993 with Bain Capital to effect a consolidation strategy for the highly fragmented nutritional supplements industry. Since inception, the company acquired a number of businesses (e.g. Solaray, Premier One Products, KAL, Monarch Nutritional Laboratories, Action Labs, NutraForce), and in FY98 (Sept.) the company reached $100 million in sales and went public at a price of $17.5. After completing a couple more acquisitions and with net debt at $36 million at end of FY00, the company was hit by an industry slowdown. The result, as inevitably occurs with most roll-ups, was that the stock tanked, falling to a low of under $2 in early 2001.

Despite the meltdown in the stock, the company made a concerted effort over the last three years to cut costs and squeeze every nickel they could from their business, to restrain from making only but a select few accretive acquisitions (and paying cash for them), and to use its strong cash flow to aggressively pay down debt. The net result (from FY00 to the just completed FY03) is quite remarkable: net debt has been reduced from $36.2 million to $10.3 million; operating margins have increased from 13.1% to 16.9%; EPS has grown from $0.47 to $1.09; and, the stock has risen from $2 to $13. ROIC now stands above 20%. With its current low valuation and with the current activities in its business and a catalyst in place (see below), NUTR looks interesting.

ABOUT THE BUSINESS

The company’s $125 million in FY03 sales breaks down as follows: 83% branded products, 11% retail stores, and about 6% bulk products. The company manufactures about 85% of its products, which it views as a competitive advantage because it can more closely control product quality. NUTR has won various awards from magazines and customers for the quality of its products. The company has over 3,000 SKUs (200 of which were introduced in FY03) with no product category accounting for more than 5% of sales.

The long-term underpinnings of the company’s market appear quite solid. The company’s focus has been on the VMS industry (vitamins, mineral, herbal and other nutritional supplements), an $18 B market. The industry has averaged growth in the low single digits, though it has been relatively flat over the last couple years, primarily due to the slow economy.

The company sells direct (with its own salesforce) into the “Healthy Food Channel”, which it defines as the more than 15,000 retailers including (i) independent health and natural food stores, (ii) natural food chains (e.g. Whole Foods Markets, Wild Oats Markets) and vitamin store chains (e.g. Vitamin Shoppe, Vitamin World), and GNC stores. The company’s own distribution network is quite broad with no group of stores representing more than 5% of company sales.

Because the industry is fragmented, NUTR often competes with smaller, private companies. The main exception, and the gorilla of the industry if you will, is NBTY (NYSE: NTY), which has about $1.2 B in sales, roughly ten times that of NUTR. NBTY trades at 18 times FY03 (Sept.) EPS and 15 times FY04E EPS. Another competitor, Perrigo (Nasdaq: PRGO), which sells OTC pharmaceuticals and nutritional products largely under store brands, has $830 million in sales and trades at 20 times FY03 (June) and FY04E EPS. By comparison, NUTR trades at 12 times FY03 (Sept.) EPS of $1.09 and about 10 times FY04E EPS. It should be noted that Nature’s Sunshine Products (Nasdaq: NATR), with roughly $300 million in sales, sells direct to consumers and hence is not viewed as a direct competitor by company management.

While the company’s business and industry are clearly less than exciting (with the description thereof likely putting the average VIC reader to sleep, especially on this turkey weekend), the company’s valuation (on an enterprise basis) at 8.6 trailing FCF is pretty unusual in the current market, especially for a company whose business is growing (albeit slowly). Upside to earnings in FY04 (versus FY03) should come from any incremental growth in branded products (perhaps 2-3%) and two small acquisitions which were just completed. NUTR bought Arizona Health Foods (chain of 11 health food stores for $3.5 million in cash) on 7/1/2003 and Nature’s Life (brand of nutritional supplements for $10.8 million in cash) on 6/16/2003. Also important is that the company admits that they have more room to cut costs. For example, the company used to have 16 different facilities and has already eliminated 11 of them. The company is consolidating into one major facility, which has 315,000 square feet in Ogden, UT. The consolidation should be nearly complete by the end of FY04.

Importantly, the company has a clear history of returning capital to stakeholders: $10.5 million of debt was paid in FY01, $13 million of debt was paid in FY02, and $2 million of debt was paid and $1.4 million in stock was repurchased in FY03. In particular, this area got me most interested in the story in early 2002 when I submitted the idea to become a member in VIC.

The story arguably becomes a little more interesting considering that various Bain entities (pre-IPO investors) until recently owned 42% of the common. Recent selling by the main Bain LPs (around 20-30% of each LP’s holdings in NUTR) and by the two Bain directors on NUTR’s board has likely negatively impacted the stock from its recent high of nearly $15. If the overhang is ever removed, NUTR shares could arguably trade higher.

Catalyst

Stock currently trades at a low multiple of free cash flow
Company continues its history of returning capital to stakeholders
Contribution from two recent acquisitions
Any top-line growth would be highly accretive to earnings
Further consolidation to its Ogden facility
Potential removal of overhang from Bain shareholders