GNC Has Been Beaten Down, But It's Still a Good Investment

Shares of GNC have sold off huge this year, down 36% year-to-date compared to a 5% loss for the SPDR S&P Retail ETF, after the company was hit by a series of unfortunate, though not cataclysmic, events. First was a New York Times article that questioned the efficacy of vitamin supplements, which are GNC's bread and butter. GNC's revenue breaks down as follows:

  • Sports and Nutrition (sports drinks, protein powders, health bars) -- 44.5%
  • VHMS (vitamins, minerals and health supplements) -- 38.6%
  • Diet Products -- 11.6%
  • Others (media, food, and store club subscriptions) --5.3%

Vitamin and mineral supplements are a huge $30 billion-a-year business in the U.S., where one in every two adults pops a vitamin pill daily.

The story first appeared in an editorial in the journal ''Annals of Internal Medicine,'' where it went largely unnoticed. But the New York Times enjoys a far bigger readership, and a recap of the story on its website did the damage. According to the claims, all vitamin supplements, with the exception of Vitamin D which is still under investigation, do not add any value and are a waste of money.

The second unfortunate event was GNC's disappointing first-quarter fiscal 2014 results. Although the company's top line grew 1.7% during the quarter to $667.3 million, same-store sales fell 0.7%. Earnings per share also increased a modest 2.7% to $0.75. The small top-line growth was mostly driven by the addition of 153 net new stores in 2013. The company also cut its earlier earnings guidance for fiscal 2014 by $0.10 to a lower range of $3.05-$3.10, which represents 7%-9% growth.

Inclement weather negatively affected GNC's sales in the months of January and February.

Another key concern about GNC is its rather lopsided balance sheet. The company sports $1.3 billion in debt, but just $200 million in cash. But its interest coverage ratio (a measure of how easily the company can pay off interest on its debt) is close to 9, which is a good ratio--the interest coverage ratio should ideally exceed 1.5.

Highly profitable
Despite all the woes facing GNC, the company remains highly profitable -- so profitable, in fact, that it's in the top percentile in its industry in terms of profitability.

GNC dominates the industry niche with 8,700 stores (40% company-owned) compared to 600 for Vitamin Shoppe , its closest competitor. About 82% of GNC's sales come from its own proprietary brands such as Mega Man, Total Lean, and Ultra Mega. Proprietary products command higher margins than the company's other products, and their growth from 47% of retail sales in 2007 to 56% currently has been instrumental in improving the company's operating margin from 10% to about 18%. GNC's operating margin is better than 99% of the 484 companies in the global pharmaceutical retail sector, which has an industry median of just 3.67%. In comparison, Vitamin Shoppe is quite profitable too, but not quite as profitable as GNC since its operating margin clocks in at 11%.

Vulnerability to Amazon
GNC has been very promotional recently with retail tricks such as Buy-One-Get-One free, or BOGO, offers. Mark Miller, a William and Blair analyst who tracks products sold at Amazon, recently told Y-Charts that the heavy discounting of GNC products is creating arbitrage opportunities for third-party sellers on Amazon Marketplaces, who are buying the products cheaply at GNC's website, and then reselling them at Amazon.

According to Mr. Miller, there were 460 GNC SKUs available on Amazon in 2012; currently the figure has grown to 1,270 SKUs. Although GNC does not see this as a big problem, the heavy promotions may soon impact the company's high operating margin.

Vitamin Shoppe is a good opportunity too
Unlike GNC, Vitamin Shoppe is not facing the effects of bad media reports. Even though it is smaller, Vitamin Shoppe has a much broader product offering than GNC, and can usually offset any weaknesses in one segment with stronger performance in other categories. For instance, Vitamin Shoppe's diet segment is a much smaller category for the company than it is for GNC. Last year, the company had really strong diet products, but this year it has fewer offerings. But this is not likely to materially affect the company's overall performance.

Vitamin Shoppe's shares trade at a forward P/E ratio of 15.6 versus 12.3 for GNC.

Final thoughts
GNC remains a high-quality retail stock with a strong industry presence. The current woes plaguing the company are more like near-term challenges than major fundamental shifts. Long-term investors should use this year's huge sell-off as a buying opportunity.

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Joseph Gacinga has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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