Description

After a successful IPO last year, insiders have bailed through a secondary and comps get very tough this fall.  Yet the stock sits on stilts at 70x earnings because the street is looking rear-view at same store comp trends which will not continue in the future, and margin projections that are unrealistic.

The Vitamin Shoppe had 463 stores at the end of Q2, and is opening 46 this year which the company states will cause approximately 1% cannibalization against 10% sq ft growth.  It competes under stiff competition with GNC, NBTY, Drug Stores, Mass Merchants, Multi-level Marketers, Internet/Mail-order, and some grocers.  It sells all sorts of vitamins, supplements, herbal remedies, sports nutrition and weight loss items.  They carry many brands including in-house brand names such as BodyTech, MD Select, and 'Vitamin Shoppe'.  The company also sells direct via catalogs which they are de-emphasizing in favor of their small but growing internet business which carries lower margins due to selling commissions to the likes of Amazon & Ebay but has lower upfront costs.

Tough comps are coming
The company touts a 19 quarter string of positive same store comps, but last fall it over-earned when the media frenzy over H1N1 Swine Flu sent people seeking herbal remedies in droves because the government forced doctors to ration the preventive shots to medical professionals and pregnant women.  Though the company now downplays estimates for this category at only 1% of sales, they touted it quite differently during the IPO roadshow last fall.  In a May 19th "no proceeds" secondary offering, insiders including management and private equity sponsor Irving Place Capital Group bailed out of 6.24m shares at $23.50. 

Same Store Sales comps were:

     2009            2010

Q1  5.1%          6.2%

Q2  4.3%          8.6% <-- did the secondry offering in May, reported Q2 Thurs 7/22

Q3  4.4%

Q4  7.0%  <-- went pubic Oct 27, 2009

Mgmt said in their Q2 call that comps were trailing off in the later part of the quarter and declined to discuss how Q3 began, although in May they were willing to tout April's good performance amid the secondary roadshow.  Mgmt said Q1's 6.2% comp was +5% traffic and +1% ticket prices, and that Q2's even bigger comp had the "majority from traffic"... Ask yourself what retailer is legitimately seeing +5% traffic these days?  These results seem rather managed for a smooth series of good numbers from IPO to exit via the Secondary.

Valuation

There are 28.5m fd shares out at $26.40 per share for a $750m market cap.  EV is over 845m with 111m of debt against approx 18m in cash.  TTM EBITDA is $72m, so the valuation is over 11.7x EV/EBITDA.  The company is guiding to $20m of FCF after spending $22m on capx.  Bonds are being paid off while the revolver expands so they shift debt to a slightly more favorable interest rate until it comes due in 2012 & 2013.  If you enter one of their stores, look around and ask yourself if the place looks like it's worth $1.825 million in EV for that store.  

Margins & Private Label
Gross Margins on Private Label brands are 50% higher than regular items.  VSI has 25% of sales in Private Label vs. 53% at GNC.  With a 33% gross margin and 25% SG&A operating expenses, the company produced an 8% operating margin vs. 9% in Q1, with sequential declines both operating and net income.  Street forward estimates assume gross margin expansion to ~35% and roughly two percent of SG&A savings to arrive at ~12% operating margin which goes far beyond the operating leverage that 10% sq ft growth implies.  Be careful comparing gross margin to competitors such as GNC because it is not an apples to apples comparison.  VSI includes store rent in their calculation giving them a lower GM%, but a smaller SG&A figure.  As best I can tell, the true difference is that VSI has about 5% lower GM% than GNC reflecting VSI's lower % of private label sales.

Carlyle likes the space
The stock of quasi-comp NBTY, Inc. (ticker NTY) blew up in April citing competitive pressures, but then on July 15^th Carlyle swooped in and bid $55 a share or 14.7x ttm EPS and 7.8x EBITDA.  NBTY is a major wholesaler of vitamins under the Nature's Bounty brand as well as the operator of the 446 store Vitamin World chain in the US (almost identical size to VSI), the 565 store Holland & Barrett chain in Europe, the 324 store Julian Graves chain (nuts/dried fruits in the UK), as well 213 additional stores of several other related retail or franchise concepts in Europe, Canada, and South Africa.  North American retail is NTY's slowest growing segment with six month sales to Q1 up 5.8% y/y delivering miniscule net margin which turned the corner from losses in 2009 amid sharp capx cuts.

Using VSI's recently expanded share count from their May 19^th "no proceeds to the company" secondary equity offering, the NTY takeout valuation implies VSI share prices of $10.52 on EPS and $16.85 on EBITDA for TTM figures.  Since VSI is growing faster than more mature NTY, using lofty street forward 2011 estimates of $36m of Net Income and $92m of EBITDA, we arrive at $19.03 on EPS and $22.46 on EBITDA using the take out multiples. 

Kookie Accounting
Though all appears to be legit and proper, they do things in odd ways.  They measure SSS comps on stores open more than 410 days, providing themselves an extra 45 days.  Presumably this is to allow a boost from double lapping their "Healthy Rewards" coupon incentives program which must be used in the first 3 months of the year or the coupons expire.  They claim it is 5 years until a store becomes mature, so 40% of the store count is not yet there.  Their rents are built into COGS rather than operating costs, and they cookie jar deferred rents from landlord incentives to be released into earnings over the leases (or when needed).  There may be a method to this kookiness, but it smells of earnings management so they can report great comps through the insider lockup period.

Risks
Demographic trends are strongly favoring this company as aging baby boomers seek increased health levels and more preventive care with greater openness to herbal/nutritional alternatives.  The 5 years until a store matures, if true, is worrisome since there will be continuing operating leverage if a $1m in Sales mature store follows a growth track that begins year 1 at 500k and adds 100k annually for five years.  However, I don't think it takes 5 years for the public to figure out there's a new store in town.  They report on Thurs. July 22^nd and I think this will be the last quarter of decent comps before they go down, quite possibly negative by Q4... And we'll see if IPC has any shares left by that point! 

VSI is beholden to a single large distribution facility adjacent to their New Jersey HQ which would hamper them if it goes offline.  They recently opened their first 3^rd party facility where they pay a monthly fee to 'receive, store, & ship' but avoid the capital cost.

There are a slew of lawsuits ranging from unfair business practices related to wage and hour violations to suits from the California DA over products containing lead.  And, they've probably lost some fans in Philadelphia because the Phillies left handed relief pitcher, JC Romero, is suing them because he tested positive for banned substances bought in their stores.   He got suspended by Major League Baseball for 50 games after consuming their "6-OXO Extreme" sports supplement probably thinking it would help with his 4.07 career ERA. 

Catalyst

• - Miss on comps, eventually going negative
• - More insiders bailing
• - Exhaust the accounting cookie jars