Description

Thesis

I am recommending a long position in Vitacost.com (VITC).  Vitacost.com is one of the largest online retailers of nutritional supplements.  VITC is a "busted" IPO operating in favorable end markets and has an activist private equity firm pushing for change at the board level.  The company was IPO'd last September 2009 at $12.  It is trading at $9.50 today because of recent management missteps in the area of manufacturing and supply management.

The company is now trading at 9x 2010 EBITDA and 6.5x 2011 EBITDA.  While there is no pure play comp, vitamin and nutritional supplement peers are trading at 9.5x 2010 EBITDA and 8x 2011 EBITDA.  I expect VITC to grow revenues at a 20% CAGR and EBITDA at a 25% CAGR through 2012.  Online companies with similar growth characteristics to VITC are trading at 13x 2010 EBITDA and 11x 2011 EBITDA.

I believe the valuation discount to other online retailers with similar growth characteristics will close over time. Great Hill Partners (GHP),  a private equity firm focused on middle market growth companies, acquired a 19.7% stake from the founder at an average cost of $11.25.  GHP is currently in the process of running a consent solicitation in order to change the composition of the board and make other positive changes at the company. This should serve as a catalyst and lead to better management accountability.

Industry

US sales of dietary supplements grew 6.3% to $25.2 bn from 2007 to 2008.  Sales are projected to grow 5% annually for the next five years.  Vitacost benefits from this growth and, more importantly, the transition to online buying for supplements.  According to the Nutrition Business Journal, the US online supplement industry will grow at a 20% CAGR from 2008 to 2017.  The online supplement market was $1.1 bn in 2009 and is forecasted to reach $4.6 bn in 2017.  VITC's 2009 sales were $192 mm.

Vitacost competes with a variety of retailers but has significant competitive advantages.  The most well known competitors are: Vitamin Shoppe, Puritan's Pride, Swanson and Vitamin World.  Mass market shops like Wal-mart, Target, Rite Aid and Whole Foods compete as well but have a different strategy.  The mass market shops typically carry a few hundred to a thousand of the fastest moving SKUs whereas VITC carries 30,000 SKUs.  The company is expanding to nearly 60,000 SKUs by year end.

Business

Vitacost's business model is relatively simple.  The company generates site traffic using search engine optimization (SEO), email campaigns, direct mail and pay-per-click (PPC) advertising.  This marketing strategy is effective and the company's average conversion-to-purchase rate for unique visitors is approximately 15%.  The company estimates that 33% of its site visitors arrive through direct navigation.

Vitacost is good at attracting customers with third party products and then "upselling" them to proprietary brands and products.  An example of this would be a "compare and save" sort of advertisement on the website when a customer is browsing a product.  In 2009, VITC realized a 58% gross margin on proprietary products compared to 27% for third parties.  VITC realizes a higher gross margin on proprietary products since it manufactures 70% of them in-house at its North Carolina facility.

VITC's customer economics are extremely attractive.  Its average sales and marketing customer acquisition cost per order was $10.74 in 2009.  Its average order value was $75.50 and with a 32% gross margin, the average gross margin per order was $24.14.  This results in a ROI on cost per order of 125%.

Vitacost's scale and ability to move product affords the company significant purchasing discounts with third party manufacturers.  According to management, VITC can offer products typically 30-60% off the manufacturers' suggested retail price.  I have talked with a few suppliers and confirmed VITC's purchasing power and believe it is sustainable.

It is also worth noting that a few brick and mortar companies, such as Vitamin Shoppe (VSI), are trying to enter the internet channel.  I have seen evidence of this but do not believe VSI is a sustainable online threat.  It will be difficult for a retailer with physical locations to price competitively with VITC for a prolonged period of time.  In speaking with VSI management, the company sells 20,000 SKUs online and 8,000 SKUs at retail.  The company prices competitively on 500 online SKUs.  It basically matches the best prices online for those high traffic items that tend to attract customers.  VSI will not do it for the remaining 19,500 or so SKUs which are priced in-line with its retail locations.  The company will then match at retail the online price for those 500 SKUs if someone requests.

Valuation

As noted above, VITC is trading at 9x 2010 EBITDA and 6.5x 2011 EBITDA.  VITC's market is $275 mm and with a net cash position of $35 mm, its enterprise value is $240 mm.

I believe there are three primary reasons for the discount:

• Lack of confidence in management and the board.
• Execution risk, especially considering the first quarter manufacturing issue.
• Further government regulation of the nutritional supplement industry.

I believe a stronger management team and board of directors would have prevented the Q1 manufacturing glitch and subsequent revenue and earnings miss.  The manufacturing glitch was the result of employee turnover in the manufacturing division and inadequate purchase order and production systems.  The company has since fixed purchase order and production systems and is in the process of hiring a new head of manufacturing.  In the meantime, Ira Kerker is overseeing the manufacturing process and according to him, is "notified within hours of any delays."  GHP is seeking four of seven seats on the board.  I believe GHP will overtime force an upgrade of the board and management team.  This will reduce the risk of bullet points one and two above.  Regarding government regulation, I have talked with a number of consultants on FDA and FTC risks.  In short, I believe the risks are manageable, especially with a qualified management team in place.  Additionally, this risk can be hedged out by shorting a basket of nutritional supplement peers.

In the near to medium term, I believe VITC is worth $15-18.  GHP does a similar analysis and believes VITC is worth $17.50 using peer multiples.  Longer term, VITC could be worth $20 as the company gains share in the online supplement space.  I believe the company has the manufacturing and distribution infrastructure in place to be a $500 mm revenue company over time.

Vitacost's annual meeting is scheduled for August 26, 2010.  Investors will be able to vote for GHP's nominated directors or VITC's four new candidates.  In the meantime, GHP has launched a consent solicitation process which requires 50% shareholder approval.  GHP's latest presentation is available here: http://investor.vitacost.com and dated June 16, 2010.

Risks

The primary risks are: management execution and regulatory.  I believe the North Carolina manufacturing issue has been resolved, but, as an outsider, it is impossible to know for sure.  There is also the risk an online giant such as Amazon decides to enter the market.

Catalyst

• 1) GHP is successful in changing the composition of the board.
• 2) Growth in the business.