Vitacost.com (“VITC”) was previously posted on VIC and as I’ve realized with Oncothyreon Inc., people can have wildly disparate opinions on a company.  Bulls on VITC are mistakenly excited about the stellar topline sales growth, the Chief Executive Officer’s past history, and his recent open market purchases of stock.  Instead of a great long, we believe VITC is a compelling short opportunity given its history of losses and misexecution, infinite valuation, and the likelihood of a capital raise through an equity issuance in the next six months. 

Checkered History

VITC is an online retailer and distributor of nutritional supplements with over 30,000 third party SKUs and 800 proprietary SKUs.  Shortly after its IPO in September 2009, Wayne Gorsek, Co-Founder and Chief Operations Architect resigned along with the VP of Manufacturing.  In March 2010, Gorsek sold all of his stock to private equity shop Great Hill Partners (“Great Hill”), for $11.25/sh or 6% below the IPO price.  Great Hill became the company’s largest shareholder owning 19.7% of the company.  As a welcoming gift, the company adopted a stockholder rights plan preventing Great Hill from acquiring more stock.  The company was so excited by Great Hill’s investment that it gave a second welcoming gift a month later by lowering its quarterly guidance due to a manufacturing issue.  Upset by the company’s welcoming gifts, Great Hill solicited shareholders in an attempt to replace the Board.  Realizing that the party was over, the company hired Oppenheimer in May 2010 to explore strategic alternatives as part of a ploy to appease shareholders.  Shareholders and Great Hill were unhappy with management’s negligence, and Great Hill won control of the company through a proxy battle in July 2010.  The company then replaced CEO Ira Kerker with Jeffrey Horowitz (the current CEO), as well as the CFO.  The board then canceled the strategic process in August 2010 citing no reason, but investor relations commented that nothing material came from this process.  For those shareholders that thought Horowitz’s appointment as CEO would be a new beginning, they were again soon disappointed.  His first act as CEO was to implement a strategic review that found an accounting issue with the company’s share count.  As a result, the company delayed its quarterly filing and the NASDAQ subsequently halted trading on the stock from December 2010 to June 2011. 

Competition

While the company was trying to get its financial house in order, VITC’s competition was working to make life more difficult for them.  There is no pure play online retailer of nutritional supplements, but VITC competes against other nutritional supplement providers such as Vitamin Shoppe (“VSI”), GNC, other online retailers such as Amazon (“AMZN”) and Puritan’s Pride (“PP”), multi-level marketers, grocery stores, as well as mass market retailers such as Walmart and Target.  VITC competes primarily on price, selection, and the speed of delivery. 

In the previous VIC write-up, it was noted that competitors such as VSI and GNC had entered the internet channel, but that they would be unable to compete effectively against VITC.  VITC’s topline and gross margins reveal a much different picture.  According to VITC, the competitive environment started in Q1 2010, has severely impacted its sales, and management does not expect this to abate.  Due to competition, the company watched its sales growth slow to a crawl in Q3 2010.  In order to boost its sales growth, the company increased its promotions thereby impacting the company’s gross margins.  The company eventually achieved sales growth of over 20% YoY by giving up 3.6% of gross margin.  Clearly management has not figured out how to grow the company’s topline in this competitive environment without impacting profitability. 

 The two most direct competitors are VSI and GNC.  As the previous write-up pointed out, VSI is unable and unwilling to compete online on price due to its brick and mortar presence (see table below).  What wasn’t mentioned was that there is plenty of other competition such as AMZN, which is just as competitive as VITC on price.  In addition, if you are an AMZN prime member, shipping is free on any order (in addition to other perks).  As many other businesses outside of VITC have learned, competing against AMZN on price, selection, and speed of delivery is a losing proposition. 

Looking at the chart you will also see that PP, a subsidiary of NBTY, has even cheaper prices than VITC.  While PP’s internet sales were only ~$150mm in 2011, the company has a much greater advantage than VITC in terms of scale (NBTY did ~$3b in sales in the LTM period, or 12x VITC’s LTM sales) and speed of delivery (4 distribution facilities compared to VITC’s 2 distribution facilities).  Although it lacks in terms of selection, you can see the benefit of PP’s scale as many of their items are significantly cheaper allowing the company to offer buy-one-get-one free promotions and even buy-two-get-two free promotions.  It’s no wonder VITC’s margins have continued to deteriorate. 

Note: It is easy to see that in a business where a primary point of differentiation is price, VITC does not differentiate itself.

While VSI may not compete on price, as noted on their most recent conference call, they are “continu[ing] to make significant investments in people, content and functionality to position [themselves] for more growth” in their internet business.  We take this to mean that the company has no plans on giving this high growth market to VITC.

Another player with significant scale and distribution advantages is GNC.  It recently acquired LuckyVitamin.com (see “Risks” for valuation) in August 2011 to enter “into the price competitive, third party assortment channel.”  Unlike VSI, GNC is not worried about cannibalization of sales in their brick and mortar stores from LuckyVitamin.com because there will be no GNC branded products on LuckyVitamin.com allowing the company to price online products competitively.  LuckyVitamin.com will also benefit from GNC’s much larger manufacturing facilities, distribution network, purchasing power, and product development dollars  to “expand in the marketplace and [to] continue to take market share.” 

It is difficult to imagine how capital constrained VITC (see “Imminent Equity Issuance”), will be able to compete effectively against VSI, GNC, PP, and AMZN, all of which have much larger balance sheets and resources.   

Deteriorating Fundamentals

While it has been over 6 months since the company resumed trading and over a year since Horowitz took over as CEO, the company is still working through issues that have severely impacted the company’s fundamentals.  The company’s topline has decelerated from a CAGR of 46.6% from 2004 to 2009 to a CAGR of 12.5% from 2009 to date, while gross margins have declined 10.0% from 32.7% in Q1 2009 to 22.7% in Q3 2011. 

 As management noted in their June conference call, “[g]ross margins [were] impacted by an increased promotional environment and a mix shift… with increased sales of lower margin third party products accounting for a greater percentage of total revenue.”  We anticipate continued gross margin pressure as the company continues to increase its third party SKUs (+1,297 in Q3 2011 alone) compared to its proprietary SKUs (+130 year-to-date).  

I would also note that VITC’s gross margin was artificially inflated in Q3 2011 due to accounting games.  During the quarter, management hired a consultant to generate freight savings and booked these savings in gross margin while the fee paid to the consultant is booked below the gross profit line in a line item called “fulfillment.”  Unfortunately the company will not disclose the exact amount of gross margin benefit so we cannot compare gross margins on an apple-to-apple’s basis.  I suspect that the majority of the 1.5% improvement is due to accounting given that in the last 10 quarters the most gross margins improved was only 0.7%. 

 While it is difficult to know peers’ gross margins as these businesses are small subs of larger companies, GNC does disclose that their GNC.com has operating margins of >20%.  Looking at VSI, operating margins in the direct business are in the high teens.  Given that both VSI’s and GNC’s operating margin is at a comparative level to VITC’s gross margin, it is safe to assume that gross margins at both of these competitors are much higher than VITC.  As peers’ margins are much higher, they have room to compete against VITC and take share through promotional activities. 

Valuation

On 2012 sell-side estimates, VITC trades at 21.0x EBITDA.  This compares to brick and mortar nutritional retailer peers who trade at a median of 10.4x forward EBITDA and online retailers who trade at a median of 14.4x forward EBITDA.  While most retailers are valued on an EPS basis, given VITC’s near infinite valuation on EPS and infinite valuation on any other earnings metric, we have highlighted EBITDA.  Based on our estimate of $5mm in EBITDA in 2012 and using the median multiple of online retailers of 14.4x, we believe VITC is worth $3.06, or 53.0% below the current share price.

It is also worth noting that sell-side estimates assume that gross margins increase to 27.1% in Q4 2012 from current levels of 22.7% in Q3 2011.  This looks to be on the assumption that 3^rd party sales growth slows and proprietary sales increase thereby improving mix.  It seems that sell-side didn’t bother reading the Q3 2011 conference call as management states “[g]oing forward, we would expect to see our third party sales continue to outpace proprietary sales reducing overall gross margin.”  When asked about sell-sides estimates, investor relations pointed us to a “very heated” promotional environment with increasing competition, and continued shift in mix to lower margin third party products.  I interpreted IR’s comments as “sell-side is most likely out of their mind.”  On the conference call, management does note that as an offset to the above factors, they expect gross margins to continue to benefit from savings generated from efficiencies (from the consultant) for the remainder of 2012, but as I have explained previously, this improvement is artificial.  We think sell-side’s estimates are a classic case of sell-side modeling unrealistic assumptions and setting the company up for future earnings misses.  While we try not to read into tea leaves (unless it’s ONTY) the company pulled out of the January ICR conference a few days before its scheduled presentation and meetings.  In our experience, companies don’t do this on the back of an excellent Q4.

Imminent Equity Issuance

With all of VITC’s issues over the past 2 years, it is no surprise that the company’s financial position has been affected as well.  At the end of 2009, the company had $39.1mm in net cash compared to $12.8mm at September 2011.  On the most recent conference call, the CEO stated that management “believe[s] [they] have enough cash on the books to do business going forward.”  We believe that the company is being optimistic given that they have been underinvesting in working capital and delaying capital expenditures in order to conserve cash. 

Over the past twelve months, sales have grown at an average of 19.4% while inventory has only grown at an average of 4.6%.  The company is clearly under-spending on inventory to conserve cash.  In addition, the company has stopped all growth capital to conserve cash.  Another reason we think growth slows or VITC issues equity to support future growth.

At the end of the day, this is a growth story, and you can’t have a growth story without the capital to grow.  While the company believes that $12.8mm in cash on the balance sheet is enough to do business going forward, we disagree.  Normalizing for inventory and capital expenditures we believe the company will, at maximum, have $0.3mm in cash by the end of June 30, 2012.  Our math is as follows:

 I would note that we see this as optimistic as we have gross margins expanding 140bps by the end of Q2 2012 to be conservative (above gross margin is blended). 

Jeffrey Horowitz (CEO)

Investors are excited that Jeffrey Horowitz is in charge of the company given his long and successful history in the nutritional space.  Touching on his history, Horowitz founded VSI in 1977 and ran the company until his departure.  During his time at VSI, he grew the company from one store in New York, to over 100 across the US.  With over 30 years in the nutritional space and his success at VSI, it is easy to see why bulls are excited. 

Bulls also love the fact that Horowitz had managed a previously publicly traded internet retailer called VitaminShoppe.com.  Just reading VITC’s press release for when Horowitz joined VITC, it notes that he “greatly expanded [Vitamin Shoppe’s] online presence beginning in 1998 with the launch of VitaminShoppe.com.”  To provide you with a bit of background on VitaminShoppe.com, it was initially launched in April 1998, and subsequently spun off from VSI in the summer of 1999.  Kathryn Creech, the CEO at the time of the spin, left a few months after the IPO and Horowitz took over in January 2010 (sound familiar?) with the stock trading at ~$8.00/sh.  Instead of delivering profits during its first year as a public company as he predicted, he delivered a $61.3mm net loss.  A year after taking the helm, the stock was trading below $0.50 in December 2000 before VSI bought the company back for $1.00/sh.  The bulls have forgot the $34mm in cash he lit on fire and the 90% negative return Horowitz provided shareholders as CEO of a publicly traded online nutritional retailer.    

Having run a company with a similar business model to VITC, it is important to ask “what went wrong?”  Reading through the Q3 2000 press release reveals that he was having a problem balancing growth and margins (sound familiar?).  As was indicated in the press release, he eventually gave up sales growth to conserve cash and improve gross margins.  VITC’s deteriorating fundamentals show he has not yet figured it out, but as Buffet likes to say “[w]hen a management team with a reputation for brilliance tackles a business with a reputation for poor fundamental economics; it is the reputation of the business that remains intact.”

Investors also point to Horowitz’s recent stock purchases on the open market.  To date he has purchased a little under 600k shs for a total value of ~$3.2mm at prices on a weighted average 20% below the current share price.  These are decent sized purchases, but this is not a material amount of Horowitz’s net worth.  To put this in perspective, Horowitz’s preferred and common stock in VSI’s IPO was worth at least $35mm.  While it is difficult to know for sure, we estimate Horowitz has accumulated a net worth between $80mm and $120mm over his career. 

Conclusion

VITC presents a compelling opportunity to short a company with a history of misexecution, unreasonable expectations, absurd valuation, and a near term catalyst. 

Risks

1. Beat on Q4 2011 results (expected in early March) – while this is a risk, we see it as unlikely given that the company is continuing to work through its historical problems, the increased competitive and promotional environment, and the lack of growth in its proprietary products.  As was previously noted, the company also pulled out of the January ICR conference, which we believe does not bode well. 
2. Debt financing – given the current economic environment, the company’s historical issues, and its lean balance sheet, we see it as unlikely that a bank is willing to extend a credit line. 
3. Announcement of strategic plan – over a year after joining the company, Horowitz has yet to announce his strategic plan.  The company has not given any color on when this announcement will occur, but given management’s reluctance/inability to guide investors, any help would likely be a positive to investors.
4. Takeout – it seems unlikely that the company is taken out by a strategic peer as the company has nothing of value that someone like VSI or GNC would need.  It also seems unlikely that Great Hill takes the company private given the lack of cash flow and the rocky history.  In addition, using GNC’s takeout multiple of LuckyVitamin.com implies that VITC is worth 12% below the current share price, giving us comfort that our downside is protected.  Our math:

   LuckyVitamin.com:
   GNC purchase price			$22.0
   2011E Sales			$45.0
   EV/Sales Mult			0.5x
   VITC implied sh price			$5.79
   vs Current			-12.1%