Nutraceutical is an ultra-high quality cash-flow machine, trading surprisingly, at 5.4x LTM EBITDA and 10.3x earnings. We believe the stock is low risk with 50% upside.  A five-year average ROA of 14.5%, EBITDA margins of 18.5%, a pristine balance sheet with almost no debt and insider ownership of more than 10% distinguish it.  Moreover, the consolidation of six acquisitions concluded in the last 12 months and the conclusion of a three-year capex program will serve as major catalysts that will propel top and bottom line growth and subsequent equity appreciation.

 

The write-up will focus on the issues that have led to recent underperformance.  Further, deeper analysis of these issues provides perspective on their significance for the future.  This is quantified in 2008 expectations and a valuation which shows just how undervalued this security is.  Lastly, risks associated with this opportunity are presented.

 

Please see the following two VIC submissions for an excellent summary of Nutraceutical’s business.

 

 

 

In brief, Nutraceutical is one of the nation’s largest manufacturers and distributors of nutritional supplements.  Business is divided between ~30 “Brands” of which Solaray and KAL are the two most well known, and “Retail” which consists of ~25 retail stores.  The company sells almost exclusively into the health and natural food store channel (~15,000 retailers including Whole Foods, Vitamin Shoppe, etc.) and avoids the mass market (Wal-Mart, drug stores, supermarkets, etc.).  The company has over 30 brands, 3900 SKU’s and currently supplies around 8,500 retailers with product.  No one product or customer is greater then 5% of sales.  Nutraceutical has consistently generated high ROA and significant operating cash flow:

 

 

One would think that such a company should trade at a greater multiple then 5.4x LTM EBITDA.  While the stock has been as high as $18.12, it is currently trading much closer to its 52-week low of $10.67 for the following reasons:

 

In 2007 Nutraceutical grew total sales by 4.1% from $150.4 million to $156.6 million.  However, this included around $13 million of acquisitions, so organic growth fell by $7 million or -5%.  Nutraceutical cites normalized organic growth of 1% to 3% so this shortfall in sales was certainly disappointing and surprising.  In fact, this was the worst organic growth performance in many years (if not in the history of the company’s public existence).

 

 

The disappointing $7 million drop in organic sales was entirely in the “Brands” business and was explained in the following way:

 

+ Whole Foods/Wild Oats merger: Wild Oats reduced product orders from its suppliers, including Nutraceutical, in 2007 as it was being acquired by Whole Foods.  Wild Oats represents slightly less then 5% of sales.

+ Whole Foods shelf space: Whole Foods reallocated shelf space away from supplements and towards “organic” clothing to bolster their social image/reputation.  Whole Foods also represents slightly less then 5% of sales.   

+ Vitamin Shoppe SKU rationalization:  As a result of overstocking at warehouses, Vitamin Shoppe executed an inventory management overhaul/SKU rationalization in 2007.  No new products were being ordered.  Vitamin Shoppe was also slightly less then 5% of sales.

+ Ground Shipping:  In an effort to lower SG&A costs, Nutraceutical moved to all-ground shipping in 2007.  Certain stores in the Northeast and Southeast that wait until product stocks run out and therefore require next-day service, shifted orders away from Nutraceutical because of the longer delivery times.

 

It is conceivable that all 4 of these trends could continue in 2008 but highly unlikely:

 

+ The Whole Foods/Wild Oats merger is complete and Wild Oats is starting to order product again. 

+ The shelf space changes that Whole Foods has made could continue, further reducing orders.  However, the talk in the industry is that this shift has not been an economic success. Note that this is not a Nutraceutical market share issue but rather, a problem for all WFMI supplement suppliers.  Nutraceutical also indicated that its retail business noticed a pickup in sales in markets that also had a Whole Foods store present. 

+ Vitamin Shoppe orders have now returned to normal. 

+ Nutraceutical is working with specific customers to help them better manage their inventory.

Organic growth issues aside, total revenue growth will be significantly higher in 2008 simply because of a whirlwind of acquisitions completed in 2007.  In 2007 the company allocated over $30 million towards acquisitions - the largest dollar amount by at least a factor of 2x since 1995 – as a result of favorable valuations in the deal-market:

 

 

Nutraceutical management indicates that the acquisition environment remains very interesting, that they continue to be active, and that they are not opposed to levering up their balance sheet to $60 million of debt for the right deal (they currently have net debt of $15 million).  We have a lot of faith in management’s ability to execute acquisitions as the company was founded by Bain Capital in the early 90’s for the express purpose of rolling up the very fragmented vitamin, mineral, supplement (VMS) industry.  Indeed, the company has an excellent track record of paying reasonable multiples of 1x-1.5x sales and/or 5x-6x EBITDA and realizing significant synergies on the deals it makes.  And recent deals suggest that the company is willing to expand beyond the core VMS market to faster growing segments in the natural products market such as personal care. 

2007 bottom-line results looked pretty awful as well and have weighed on the stock.  EBITDA fell 2.3% and margins went from 18.7% in 2006 to 17.5% in 2007.  EBITDA margins were close to 5-year lows.  Diluted EPS fell by 11.1% in fiscal 2007 – the worst performance in 5 years:

 

 

EBITDA margin deterioration of 120 bps resulted in an EBITDA shortfall of $1.8 million.  The major contributing factor to the profit margin under-performance in 2007 was the outsized number of acquisitions executed last year.  Of the $156 million of total sales, around $13 million was from acquired businesses that operated at only a 10% EBITDA margin.  This is in contrast to the “Brands” business which operated at 20% EBITDA margins in 2007.  Thus this 10% margin differential between the acquired and core “Brands” business accounted for $1.3 million of the $1.8 million of the shortfall.  Under Nutraceutical’s umbrella, these acquired businesses should operate at the core “Brands” margin level of 20% within 1.5 years of being acquired.

At the outset of this report I characterized Nutraceutical as a “free cash flow machine” although one could reasonably conclude I was exaggerating if the last two years of capex are assumed to continue forward.  The table below shows multi-year lows in free cash flow generation in the last two years:

 

*Net of $4.5 million proceeds on sale of building

 

In fiscal 2006, Nutraceutical embarked on a 3-year capex initiative to consolidate its warehousing, manufacturing, packaging, distribution and administrative facilities into one location.  The company purchased a 410,000 square foot building that it was previously leasing, along with 19.2 acres of land for $4.2 million in cash, financed through the sale of a Park City, Utah building that they owned.  This is a consolidation of 19 facilities spread across a wide distance, to essentially one. Including the cost of the building, through 2007, the company has spent $16.2 million and 2008 costs of $8 million will complete the project.  Thus the three-year sum of the consolidation will be ~$25 million.

 

Cost reductions will accrue in items such as rent, facility transportation, and labor.  Process improvements will increase efficiencies and the company anticipates faster order fill rates and therefore, greater turns.  Also the facility is designed to allow for significant expansion (to 2x current capacity) and will be showcased to customers, investors, etc.  Specific cost savings attributed to this consolidation include rent decreases of $500k/year and transport cost reductions of “easily” $100k-$150k per month or $1.2-$1.8 million annually.  Total cost savings will be in excess of $2.5 million annually (some to be recognized in 2008 but the vast majority in 2009) implying at least a 10% return on the $25 million investment.  With all of the additional benefits, this three-year project represents a significant catalyst for the company.

 

Note that maintenance capex for the business is $4 to $5 million.  Once this project is completed the company expects to return to this level of capex, suggesting that free cash flow in the coming years will be substantially higher then in recent past years.

 

A deeper analysis of the growth, profit and capex spend issues suggest the stock has been unfairly discounted.  To quantify a fair value for Nutraceutical, we constructed a downside, base, and upside case for 2008 revenue and EBITDA and applied recent transaction multiples for comparable targets.  Using even the most conservative assumptions, Nutraceutical represents a compelling valuation.

 

2007A: The “Brands” business fell 5%, from $133 million to $126 million. The $17.1 million “Retail” business - Nutraceutical’s 25 retail stores - was relatively flat on the year.  Acquisitions added $13 million.

 

2008E: The primary drivers of Nutraceutical’s “Brands” revenue decline are largely behind them.  The Wild Oats merger is completed and the shelf space re-allocation at Whole Foods is done.  Furthermore, Vitamin Shoppe orders have normalized.  These three issues accounted for 70% of the 5% decrease in “Brands” revenue for 2007 (~$5 million).

 

Our downside case assumes some continuation of the above issues in 2007, or a 2.5% contraction in “Brands” revenue, versus 0% and 2.5% “Brands” sales growth for the base and upside cases.  All three cases assume no growth in “Retail” sales, consistent with management expectations. 

 

All three cases simply reflect $25 million of additional revenue as a result of acquisitions completed in 2007.  This too is consistent with management expectations and also with the stated 1.0x-1.5x revenue a multiple for $30.7 million of acquisitions.  Note that we are not factoring in any growth in the acquired businesses despite the fact that a few of the new product lines (i.e. creams) fall into the faster growth personal care segment of the natural products industry.

 

The above assumptions imply 2008E revenue growth of 5.6%, 7.6% and 9.7% for the down, base, and upside case. 

 

2007A: EBITDA margins of 17.5% in 2007 reflect 19.9% and 5% EBITDA margins for the “Brands” and “Retail” businesses, respectively.  2007 acquired businesses operated between 10% and 12% EBITDA margins.

 

2008E: Our downside, base and upside cases all conservatively reflect no change in EBITDA margins for the either the “Brands” or “Retail” businesses.  We only assume EBITDA margin improvement for the acquired businesses to 15%, 17.5% and 20% in 2008.  Management has confirmed that the acquired businesses, which are all branded products, have great potential for margin expansion and should operate at similar levels to the core “Brands” business within 1.5 years of being acquired.

 

The above assumptions imply 2008E EBITDA growth of 6.1%, 10.7% and 15.3% for the down, base and upside case.  While management expects to see at least some savings through its capex consolidation in 2008, to remain conservative, we do not include this in our model.

 

To determine fair value for Nutraceutical we analyzed two comparable transactions: Plethico’s November, 2007 acquisition of Natrol, and NBTY’s August, 2005 acquisition of Solgar.  Both target companies were either EBITDA negative or close to it at the time of acquisition versus Nutraceutical’s current 17.5% EBITDA margin.  Amazingly, despite the vast difference in profitability, Nutraceutical currently trades at a discount to the average LTM sales acquisition multiple of 1.11x.  We applied a “hypothetical” 17.5% Nutraceutical-level EBITDA margin to Natrol and Solgar sales, and found that they sold for 6.35x which is substantially more than the 5.4x EBITDA that Nutraceutical currently sells for.  Applying these average transaction multiples to Nutraceutical LTM numbers yields an equity value/share of $14.25 or 18.75% above where the stock currently trades.

 

Applying multiples of unprofitable businesses to Nutraceutical metrics seems overly draconian, despite the fact that it yields a stock price that is 18.75% greater than the current price.  Nutraceutical expressed interest in acquiring Solgar in 2005 but ultimately was rebuffed, despite supposedly offering $15 million more or 1.27x sales and 7.3x hypothetical EBITDA.  Valuing Nutraceutical at those multiples yields an equity value/share of $16.50 or a 37.5% premium to the current price.

 

Note that the valuation analysis above does not factor in 2008 or 2009 results.  This is doubly conservative since 2007 revenue and EBITDA performance was poor and because 2008 holds much promise as does 2009.  Applying the 1.27x and 7.3x sales and EBITDA multiples to base case 2008E values yields an equity value/share of $18 or a 50% premium to the current $12 price. 

 

Nutraceutical’s 10K provides an excellent list of major risks associated with the company.  In addition to this, note the following:

+ Wild Oats and Whole Foods represent ~5% of total sales each, and further declines in orders from either or both could continue to hurt organic sales growth.

+ The shift to ground transportation could prompt customers to turn to competitors who might supply product more expeditiously.

Lack of growth and profit deterioration has pummeled Nutraceutical’s stock.  However, the company is well positioned to put its uninspiring two-year performance behind it.  Integration of 2007 acquisitions will fuel growth and profitability significantly.  Cost savings accrue to the company in both 2008 and (largely) in 2009 as a result of the three-year capex consolidation project.  Furthermore, the company has stated that the plant consolidation and land holdings project could support twice what Nutraceutical currently produces.  With its excellent cash flow generation potential, historic and current low level of debt, and acquisition integration expertise, this expansion potential suggests a possible long-term strategy that could see the company do a major acquisition sometime in the next two to three years.