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GNC may miss cash flow goals

August 13, 2017

GNC reiterated a free cash flow target of $250 million for 2017.

Free cash flow through the second quarter was $54.2 million, resulting in a $195 million deficit for the second half.

Our projections suggest that GNC will fall short of its free cash flow goal.

Nonetheless, there remains compelling value if the company can stabilize the business and address the debt maturities.

 

GNC (NYSE:GNC) reported improved (though still mildly negative) results for the second quarter. The results were largely in line with our projections for revenues, profitability, and cash flows, as outlined in our previous article. The primary exceptions were that same-store sales came in slightly higher than we had projected (-0.9% versus -2.0%) and gross margin was higher than anticipated (33.2% versus 31.0%), although this was in part related to a one-time benefit associated with vendor funding. The greatest surprise, though, was on the cash flow side as accounts payables fell substantially during the quarter, resulting in a significant cash flow drain. Nonetheless, the company reiterated its target of $250 million in free cash flows for the year despite year to date free cash flows of only $54.2 million. The result is a deficit of $195 million which must be made up in the next two quarters.

In this article, we more closely examine the potential drivers of the free cash flow projection to determine the probability that the company will ultimately be able to achieve these results. We consider this an ambitious target – indeed, we believe the company has unnecessarily overcommitted – and provide details of our analysis and projections to support this position.

GNC’s cash flows are actually surprisingly straightforward, so it’s reasonably possible to make an assessment of each potential source of free cash flow and compile those figures to determine the likelihood of the company reaching the $250 million objective.

Operations

The company’s core source of free cash flow is cash flow from operations before any changes to the working capital accounts (primarily accounts payable, inventories, and receivables). We consider free cash flows from operations to reflect net income with adjustments for depreciation, amortization, stock based compensation, and impairments, less capital expenditures. The cash flows from operations effectively establish a floor for free cash flow. The adjustments to working capital accounts can then be added or subtracted from this base, as appropriate, and form the initial starting point of our analysis.

Our model projects free cash flows from operations, assuming continued stability in the business, to fall within the range of $125 million to $135 million per year. We consider this the company’s base ongoing free cash flows from operations barring any significant changes in net income, gross margin, or capital expenditures.

Source: Company Financial Reports and Proprietary Projections

We are reasonably confident in this projection since the key components of this calculation have historically been surprisingly stable from quarter to quarter and year to year. In fact, depreciation expense and stock based compensation cash flow impacts have been essentially unchanged to marginally positive over the last three years, while amortization of debt costs has increased but remained essentially flat for the first two quarters of 2017. Obviously, there is inherent risk in making projections around these values, but we consider the margin of error to be relatively small, possibly plus or minus $5 million, which can easily be taken into account as a sensitivity factor when evaluating our consolidated projections.

We are compelled to note that this is a significant cash flow figure and doesn’t suggest to us that the company would have problems working through its current long-term debt load, provided the company continues to stabilize operations and the maturity issue is addressed satisfactorily. We believe that there are available lenders who would be willing to finance the company on acceptable terms, provided there is not another significant downturn in sales, profit margins, or net profitability.

It’s also worth noting that the company confused the situation somewhat in the second quarter call with the statement that a third of the company’s $250 million free cash flow target would come from cash flows from operations and the balance from working capital accounts. Clearly, this would suggest a significantly lower net income figure than implied by the company’s other statements regarding sales, gross margins, etc. We questioned the company on this point, and the company responded that the statement was a shorthand statement and that the “operating figure” only applied to net income (i.e., didn’t include any benefit from depreciation and amortization or offset for capital expenditures). In other words, net income would represent about a third of the $250,000, which is about $82.5 million, roughly in line with the company’s other projections and slightly less than analyst estimates. The company indicated it would likely clarify this statement in a future call.

Same Store Sales

Same store sales remained negative though on a much better trajectory than prior quarters. Interestingly, absent the revenue benefit of the former Gold Card program, revenues were relatively stable from the prior year period.

Our model continues to show that same-store sales improvements in the second quarter will not materially impact free cash flow for the current year. This assessment is supported by the company’s own statements in the first and second quarter conference calls, specifically:

  • that gross margins for the year will remain in the current 31% to 33% range;
  • that SG&A expenses as a percentage of revenue will remain around the current 24% (or possibly slightly higher) for the balance of the year;
  • that operating leverage is insignificant until same store sales improvements reach at least the 3% range.

In addition, the company’s own implicit projections for net income based on the comment regarding free cash flows suggest that net income will be in the range of $85 million, plus or minus a few million dollars. This value is confirmed by our own models in addition to being in line or slightly below current analyst estimates.

We therefore view expectations that same store sales growth in the second half of the year will contribute materially to net income and/or free cash flow anywhere approaching the degree necessary to close the free cash flow gap in our projections is wishful thinking unsupported by field evidence, the financial community, or the company’s own operating projections.

In fact, our models suggest that the net positive impact to net income and free cash flow of a 100 basis point increase in same store sales in any given quarter is less, and possibly substantially less, than $1 million. We consider it unlikely that the company will achieve high single digit same store sales results in the back half of the year, especially given the company’s own statements and, therefore, believe that any positive benefit from same store sales increases through the remainder of 2017 to free cash flow will be essentially immaterial.

The remaining primary potential sources of free cash flow for the company are accounts payable, inventories, and receivables, so let’s evaluate these components.

Inventory

Inventory has been highlighted as a key potential source of free cash flow for the company. The sources of free cash flow will come through reduction of inventory and the potential closure of stores.

In order to assess inventory reduction opportunities through reducing store inventory, we assessed inventory levels through three separate methods. We assessed days of inventory based on cost of goods sold on both and average and ending inventory level, as presented in the following table:

Source: Company Financial Reports

In addition, we compiled data with respect to finished goods inventory and the corresponding period company owned store counts to determine an average finished goods inventory level per store over time from 2012 through 2017, as presented in the following table:
Source: Company Financial Reports

In estimating average inventory per store, we elected to use finished goods inventory rather than inventory, including work in process and packaging materials since we believe this provides a better representation of the inventory level on a per store basis since a significant amount of work in process and packaging materials inventory is associated with the far larger franchised and store-in-store base. However, finished goods also includes finished goods in inventory intended for franchise and in-store locations, so it remains an imperfect estimate of the average inventory per company owned store. Still, we believe that the offset between excess finished goods inventory attributed to company owned stores and the under-representation of work in process and packaging inventory associated with company owned stores mitigates the potential estimation error. In addition, given that the company’s finished goods inventory is consistently in excess of 80% of total inventory, we believe we can accommodate errors in the estimates within our cash flow model.

On this basis, average in store inventory has clearly been increasing over the last five years:
Source: Proprietary Calculations

In early 2012, average store inventory was in the range of $127,500 per company store location before rising to as much as $157,900 per company store location in the third quarter of last year, which is also reflected in the days of inventory figures in the earlier table. The company has since made meaningful progress in reducing average store inventory to $139,900 as of the second quarter but still significantly exceeds the average store inventory of a few years earlier.

In our conversations with the company, the company indicated a target of returning to the average store inventory levels of “three to four years ago” which we interpret as the low point achieved in 2012. The company plans to do this by reducing the carrying amount of inventory to better segment the market and tailor inventory levels to demand and by reducing the number of SKUs in store locations.

We therefore can establish an estimate of the potential benefit to cash flows assuming the company can achieve average inventory levels comparable to that time period. We established the range of potential values we would consider as $127,500, $130,200, and $134,800, as the lower, midpoint, and upper targets based on the results achieved during 2012 and assessed the potential reduction in inventories if the company were able to return to these average levels. The results of these estimates are presented in the following table:

Source: Proprietary Projections

However, it’s necessary to adjust the store count for potential store closures to avoid double counting inventory reductions. The impact of store closures is discussed later in this article. In order to do so, we elected to assume that the per store inventory reduction benefit would occur over a company store base with a net reduction of 75 stores for the balance of the year, roughly representing a midpoint in the possible range of net store closures.

We believe it’s unlikely that the company would be able to achieve inventory levels lower than the low of $127,800 established in the first quarter of 2012, certainly not within the balance of the year. In addition, the company has also acknowledged that reducing the number of SKUs will have a negative impact on revenues. The higher number of SKUs introduced into the stores over the last few years increase revenues, but the company has since decided that the increase was not sufficient to justify carrying the additional inventory. We don’t have sufficient information to assess the potential impact of reduced sales associated with a narrower range of SKUs, but our sense is that the impact would be neutral to slightly negative and have not included any allowance for this impact in our current model.

It’s also possible that the company will find meaningful opportunities to reduce inventory levels in its work in progress and packaging materials segments of inventory. However, reductions in these areas would be relatively small compared to the reduction in finished goods and, in addition, can be reasonably accounted for within the sensitivity analysis.

In regard to the potential closure of stores, the company stated during the second quarter conference call that it expects to close around 200-250 company locations in the current year primarily by not renewing existing leases as they come up for renewal. The company has closed 75 company locations in the first two quarters with the potential to close another 125-175 locations through the end of the year.

In this case, it would be possible for the company to realize inventory reductions of approximately $21 million, plus or minus $3.5 million, depending on the number of stores ultimately closed during the year.

However, this figure may be somewhat misleading since this does not represent a net number of store closures but an absolute number which may be offset by the opening of new locations and/or the conversion of franchised stores to company stores through the end of the year. Indeed, while the company did close 75 stores in the first half, this reduction was nearly entirely offset by 36 new store openings and a net acquisition of 35 franchised stores. The result was a net reduction of only seven store locations in the first half of the year, likely representing roughly $1 million in inventory.

It’s possible that the company will accelerate net store reductions in the last half of the year or improve the conversion of company stores to franchise stores, which would reduce inventory. However, the company is not presently on a clear path towards a meaningful net reduction in company owned stores and actually stated during the call that “we’re not suggesting that it’s going to be a meaningful change in store footprint.” We therefore consider a projected reduction in inventory based on store closure anywhere near $21 million to be unlikely or, at best, at the high end of potential inventory reduction associated with store closures.

Accounts Payable

The above estimates for potential reductions in inventory also provide a basis for assessing the potential cash flow impacts of changes in accounts payable. In discussions with GNC, the company stated to us that its internal target for accounts payable is approximately 30% of inventories. Of course, as inventories adjust, this will inversely impact the accounts payable line, so the cash flow benefit of inventory reductions will be partially offset by lower accounts payable.

We can calculate the range of projected year-end inventory levels based on the inventory projections above, as reflected in the following table:Source: Proprietary Calculations

We can then use the company’s own stated target for year-end accounts payable as a percentage of inventory and estimate the related cash flow impacts as presented in the following table:

Source: Proprietary Calculations

Receivables

The most surprising component of the balance sheet and cash flow statement for us has been the decline in receivables in the first two quarters of the year. The company does not go into significant detail on the composition of receivables although the majority of the balance is likely related to product sales to franchisees and third party sellers with the occasional component related to future proceeds associated with refranchising activities. Receivables as a percentage of total revenues have been surprisingly consistent over the last several years with a slightly declining trend, as reflected in the following table:
Source: Proprietary Calculations

However, receivables have continued to decline in the first half of the year at a rate significantly higher than that of revenue, resulting in a decline in the receivables to projected annual revenue ratio to 4.7% as of the end of the second quarter. It’s not clear based on the information provided by the company to date what’s driving this decline, and this will be a point of discussion with the company going forward in order to clarify the reasons for this trend. However, absent specific information, we’re inclined to believe that the trend from prior years will ultimately prevail and that ratio of receivables to sales will likely fall in the range of 4.7% (best case) to 5.3% (worst case) with a midpoint of 5.0%. The resulting projected cash flow impact based on this range is negative for the balance of the year, as reflected in the following table:

Source: Proprietary Calculations

Other Potential Sources

The remaining potential sources of free cash flow are all significantly smaller than potential contributions from operations, inventory, accounts payable, and receivables, but we nonetheless factor these into our analysis. The company provides relatively little information on these categories, so there is a greater degree of uncertainty around the potential contribution (or deduction) attributable to these sources, as noted in each category.

The first is prepaid and other current assets which ended the second quarter at $36.8 million. The company does not provide any appreciable detail on the composition of the prepaid and other current asset account. The cash flow contribution of prepaid and other current assets has varied dramatically on a quarter to quarter basis, as reflected in the company’s quarterly cash flow statements, but a review of the year end account balance going back to 2009 shows that prepaid and other current assets have remained between $27.1 million and $47.1 million over the last several years. The average year-end balance has been closer to $40 million with the $27.1 million at the end of 2016 representing a slight outlier relative to prior years, as reflected in the following table:
Source: Company Financial Reports

We project that the best possible outcome for the company would be for prepaid and other current assets to average closer to the low point while the more probably case is that it would remain close to the current level. We therefore define the range of potential cash flow contributions to be from $0 to, under the best case scenario, a positive contribution of approximately $10 million.

The second potential source of impacts on cash flows is the deferred revenue and other current liabilities account. The company provides a reasonably detailed breakdown of the components of this line item which primarily consists of accrued compensation, occupancy expenses, interest, and other current liabilities. In the past, this account also had a significant balance for deferred revenue associated with the discontinued Gold Card, although substantially all of this deferred revenue was eliminated from the deferred revenue and other current liabilities account during the first half of the year.

The impact of deferred revenues and accrued liabilities so far in the current year has been negative, and there is little reason to believe that this trend will materially reverse in the immediate future. In particular, the closure of additional store locations, as discussed earlier, would likely reduce the balance accrued compensation, occupancy expenses, etc., and result in a negative net impact to cash flows. However, for the purposes of our best case/worst case analysis, we’re willing to give the company some credit in being able to leverage this account going forward, as reflected in our cash flow projections.

Finally, there is the ultimate wild card for potential cash flows: refranchising activity. The company has historically seen relatively modest cash flow benefits from refranchising activity with positive contribution of $3.4 million in 2015 and $3.6 million in 2014. In the first half of the current year, the company received cash proceeds of $2.2 million from refranchising, slightly ahead of the prior period pace. However, in the last half of 2016, the company refranchised a block of 84 stores in a single transaction which ultimately pushed the cash flow contribution of refranchising for the full year to $39.2 million.

Clearly, it’s essentially impossible to accurately predict the potential or timing of refranchising agreements of this scale. The company has certainly not given any indication that a comparable transaction is on the horizon and, indeed, refranchising activity for the year is overall moving in the other direction due to the reacquisition of previously franchised store locations. However, we can use the prior experience to establish a range of potential outcomes with the realization that the upper end, in the event of a significant refranchising transaction, could be significantly higher than even our projections. We therefore elected to establish the range of potential cash flow contributions to mimic prior experience by defining the lower end of the potential range as a continuation of the experience of the first two quarters and the upper end as the refranchising of a similar block of nearly 100 locations in a single transaction through the end of the year. The midpoint would be a significant refranchising transaction, but something closer to a block of, say, 25-35 stores, given the otherwise modest refranchising activity. Of course, these values are somewhat arbitrary though based on prior experience but serve the intended purpose for our holistic evaluation of the company’s cash flow prospects for the balance of the year.

So, what does it mean?

We compiled the various component projections into the following table which projects the potential free cash flows based on the ranges defined for each category to project the lowest, midpoint, and higher probable free cash flow values for the company. We did so by taking the free cash flow for the first half of the year, which is a known quantity, adding our projection of free cash flows provided by operations (including depreciation, amortization, and capital expenditures) for the balance of the year, and then adding or subtracting the corresponding adjustments to working capital and other accounts. The results of our projections, which establish a lower and upper bound, are summarized in the following table:
Source: Proprietary Projections

The bottom line is that, in our view, the company will be exceptionally hard pressed to achieve $250 million in free cash flows for the year. In order to do so, the company would not only have to hit the ball out of the park by achieving maximum inventory reduction, net store closures, receivables performance, and refranchising activity, etc., but it would also have to benefit from virtually every possible potential additional cash flow benefit. We consider this to be an exceptionally improbably scenario.

Instead, we continue to project that the company’s free cash flows will fall within a range around the midpoint estimate, or right around $200 million. This projection is not significantly different from our earlier projections for the company’s cash flows and nothing in the second quarter report substantially revised our overall projections.

Still, is it possible? In theory, but time is certainly running short, and regardless of the outcome for 2017, it remains a concern going forward that a large portion of the free cash flow – if achieved – would originate from non-recurring sources. In the event the bulk of the company’s free cash flow for the year does come from working capital sources, it significantly impairs the quality of the free cash flow as these benefits are unlikely to be repeated in future periods.

Giving Credit Where Due

We’d like to add a comment regarding management, or at least the investor relations segment thereof, for GNC. We may disagree with its internal models and/or be skeptical of certain projections for the business, but we nonetheless can unequivocally state that our contacts at the company have been forthright and responsive to our inquiries. We’re not ones to read the tea leaves, but it’s worth noting that in our experience companies that respond in the manner that GNC has to date often warrant a bias towards the positive rather than the negative.

Now, before commenting…

…it’s worth reiterating that we’re positive about GNC as reflected by our effective long position. We believe the business is fundamentally stronger than the predominant short argument, and the company is undervalued at the current market price. However, we approach our assessments of companies based on the totality of factors, both the good and the bad, and we see the cash flow argument with respect to GNC as a comparatively weak and misunderstood argument for investing in the company. In the event our skepticism is ultimately proven wrong, GNC will have been an even better opportunity than we assessed it to be under less than ideal conditions.

It’s amusing to us how frequently comments reflect a complaint about our not accepting the cherry on top despite the fact one already has an ice cream cone in hand. In our view, the ice cream cone is good enough – anything beyond that is, well, the cherry on top.

Summary

We continue to believe that GNC is undervalued given the improving stability of the business, and the company’s decent earnings and free cash flow generation potential after eliminating intermittent swings in working capital accounts. It’s more likely than not that the company will be able to refinance its credit lines and extend maturities, especially if the third quarter reflects a meaningful improvement from the prior year period and the business continues to stabilize or show positive results. The company may also show improving store performance into next year as it laps challenging prior year periods which could allow for improvement in margins by leveraging fixed costs. The company’s relatively short lease terms also provide an opportunity to reduce occupancy costs during renewals in challenged mall environments. The company’s free cash flows from operations – again assuming at least stable operations – are also sufficient for the company to service its existing debt provided the maturity issues are addressed successfully.

However, we remain skeptical of the company’s ability to reach the stated objective of $250 million in free cash flow for the year. We question whether the shorthand definition of free cash flow used as it relates to the proportion that will come from operations indicates that the $250 million figure may not, in fact, reflect free cash flow in the traditional sense. It’s possible that this may be the escape hatch for any miss in the future. However, we expect that these issues will be clarified in the future based on the company’s comments to us regarding the free cash flow figures. In addition, even if the company can achieve this threshold, it is an unsustainable run rate given that a significant portion of the free cash flow will come from non-recurring sources such as increases in accounts payable and reductions in inventory. We’d prefer, on balance, to have seen the company conservatively underpromise at a more likely target – for example, $200 million – and subsequently overdeliver if possible on the free cash flow figure.

Ultimately, the two key questions the company must address are (A) can it remain relevant despite online competition and (B) can it overcome the debt maturity issue. In our view, the company is positioned to achieve positive outcomes on both counts and represents a long-term value opportunity.

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