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GNC: A Story Of Increasing Competition And Buyout Rumors

Summary

GNC is the leading retailer of vitamins, minerals and supplements globally, both through operated and franchised stores.

The company's performance has deteriorated rapidly over the past couple of years, with strong deceleration of store metrics.

Stock is down to roughly $20 from $60 high in early 2014; debt has increased to fund significant share repurchase program.

Turnaround appears to have failed and shares currently trade on rumors of a buyout; Chinese suitors have been mentioned again.

GNC Holdings (NYSE:GNC) is a well-known VHMS retailer with a strong focus on North America. Its store portfolio is roughly balanced between operated stores and franchised stores, with a slight skew towards operated. The company intends to bring the ratio of operated/franchised stores to fifty-fifty and has announced a significant refranchising deal in H1. GNC appears to be priced attractively on most metrics, but there are some significant issues. First of all, the company has experienced very significant deterioration of store performance metrics, with domestic operated, domestic franchised and international franchised same-store sales all in negative territory during FY2015 and the last two quarters of the current fiscal year. Lackluster store performance can lead to margin pressure, which is why the company is intent on turning this situation around.

On top of that, the company also announced near the end of July that its CEO had been replaced by a board member who will serve as interim CEO. The reason for the leadership change was related to the failure of the company's turnaround plan, which had been initiated in 2014. The turnaround plan was based on five strategic pillars; refranchising a part of the store portfolio, leading an industry-wide product quality coalition, an improved customer proposition through KVIs (known value items), improvements in the loyalty program and international expansion. In the past two quarters, it really should have become visible in the company's numbers that this strategy was working. When the numbers came in, it became quite apparent that its turnaround plan was not working very well. GNC was a $60 stock at the beginning of 2014 and currently trades around $21. In this article I will take a closer look at its prospects for a successful turnaround as a standalone entity, and discuss the likelihood that the rumored buyout will materialize.

Recent performance

GNC's FY2015 performance did not look that disastrous with sales up +1% and gross margin down roughly 20bps to 37.31%, but the company needed substantially more stores in order to generate even that marginal increase in sales. Operated store count was up by +97 net units to 3594; franchised stores were down by -41 units to 3169 stores; and the shop-in-shop partnership with Rite-Aid saw unit expansion of +58 to 2327 stores. Meanwhile, same-store sales were quite poor; domestic operated LFL sales were down by -1.7%, domestic franchised LFL sales were down -2.1% and international franchised LFL sales were down by -1.3%. The expanded store base, meanwhile, had an inflationary effect on SG&A expenses, which was the main reason behind the erosion of the company's operating margin. The adjusted margin went down to 16.12% from 17.36% a year earlier, while the reported margin was 14.89% due to the write-down of its subsidiary Discount Supplements. This business was acquired in 2013 for $27.6 million and subsequently written down and certain assets sold off for $1.3 million in 2015.

Discount Supplements is a UK-based online-only retailer of VHMS products with a distinct value proposition. Such companies operate on very low margins; US online-only retailer Vitacost.com, for instance, was bought by Kroger (NYSE:KR) in 2014 and, as we can learn from its last filings as a public company, achieved a gross margin of 22.73% during 2013 and an operating loss of -3.6% of sales. Those are very different margins than what GNC is used to; its gross margin of 37.31% and operating margin of 16.12% would generally be considered very comfortable returns on retail sales. In my opinion, these margins are likely to prove unsustainable as competition increases. Kroger, for instance, bought Vitacost.com to acquire this company's online platform expertise but also as part of its effort to sell a wider range of products outside of its core grocery range. On the Q1 call for 2015, Kroger's chief operating officer described their VMS efforts as follows,

"Today we have a pretty good selection of natural foods, supplements, bodybuilding products, healthcare products in our stores. Vitacost really just helps us fulfill that long tail of items that are smaller in some cases and on the King Soopers website now, you can pick up 25,000 to 30,000 additional SKUs than what...


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