Earn a Robust 13.5% YTM with GNC, Bonds Mature August 2020

This week’s bond review takes a second look at a well-known manufacturer and retailer of nutritional supplements. GNC recently posted financial results from its first quarter 2018, surprising analysts in both revenues and earnings per share (EPS). While revenues were essentially level year-over-year (when considering one-time items), GNC had plenty of good news from its first quarter.

12% increase in free cash flow.
Private label domestic sales increased to 50% as compared to 43% a year ago.
Loyalty membership is up 12.3% over Q4.
Healthy interest coverage over 2x.

The big news is GNC’s recent agreement with Harbin Pharmaceuticals of China. This agreement will provide $300 million in capital to GNC, and will result in 40% ownership for Harbin. Also, a joint venture with Harbin will give GNC access to Harbin’s established networks and relationships, and assist GNC in the manufacturing, marketing, sale and distribution of its products within China. Considering GNC’s strong Q1 and its pending deal with Harbin in China, GNC’s 2020 bonds have been marked for additional weighting to Durig Capital’s Fixed Income 2 (FX2) Managed Income Portfolio, the most recent performance of which is displayed below.

Highlights from GNC’s First Quarter 2018 Results

In its first quarter 2018 results, GNC beat analysts’ expectations on both revenue (beat by $34.3 million) and earnings per share (beat by $0.02). The company had many positives to report in its first quarter. Here are some of the more significant highlights from its Q1 results:

Free cash flow increased 12% year-over-year, from $33.4 million in Q1 2017 to $37.4 million n Q1 2018.
GNC brand products (private label) for domestic system-wide sales increased to 50% in the first quarter compared to 48% in Q4 2017, and 43% in Q1 2017. New proprietary product introductions such as Slimvance (a weight loss supplement) and Beyond Raw (workout / performance supplement) have contributed to this increase. Building private label sales will ultimately help drive stronger gross margins for the company.
After removing one-time items from Q1 2017, adjusted EBITDA increased year-over-year by 4.6%, growing from $56.7 million (Q1 2017) to $59.3 million in Q1 2018.
Loyalty program membership increased 12.3% compared to December 31, 2017. The company’s PRO Access members (paid membership) increased 23.6% compared with December 31, 2017.

Ken Martindale, GNC’s Chief Executive Officer provided additional positive news on the company’s first quarter in GNC’s earnings call. “For the third quarter in a row, same-store sales were positive and we drove the highest gross margin in six quarters. Throughout much of 2017, we worked diligently to build, refine, and solidify our strategic initiatives. They are now taking hold and can be seen in our most recent results.”

About the Issuer

In 1935, David Shakarian opened a small health food store in Pittsburgh, PA. Even though health food was considered to be a passing fad back then, people welcomed Shakarian’s store. In the 60’s, as people began to accept natural foods and better nutrition, Shakarian met the demand by opening more stores in additional states. It was at this point when he changed the name to General Nutrition Centers, and began producing his own vitamin and mineral supplements.

GNC Holdings, Inc., still headquartered in Pittsburgh, PA, is now a leading global specialty retailer of health and wellness products, including vitamins, minerals, and herbal supplement products, sports nutrition products and diet products. The company’s shares trade on the New York Stock Exchange under the symbol “GNC.”

The Company – which is dedicated to helping consumers “Live Well” – has a diversified, multi-channel business model and derives revenue from product sales through company-owned retail stores, domestic and international franchise activities, third party contract manufacturing, e-commerce and corporate partnerships. GNC’s broad and deep product mix, which is focused on premium, value-added nutritional products, is sold under GNC proprietary brands.

The Harbin Deal

The big news at GNC is the deal struck earlier this year with Harbin Pharmaceutical Group, a leading pharmaceutical company in China. In February, GNC announced that it had reached an agreement regarding a strategic partnership and China joint venture with Harbin. Specifically, Harbin will invest $300 million in GNC, becoming the single largest shareholder in GNC (40% ownership). GNC will use the proceeds from Harbin’s investment to repay outstanding debt, general corporate purposes and enhancing the company’s capital position.

With regards to the joint venture, GNC and Hayao (the parent company of Harbin) will form a joint venture for the manufacturing, marketing, sale and distribution of GNC-branded products in China. This will help both companies to effectively leverage their respective synergies in the fast growing Chinese market. China is the largest international market for supplements and GNC is already a well-recognized brand within the country. Hayao will provide its established relationships and networks which will assist GNC in its efforts to expand within China. This includes its leading pharmaceutical distribution network in China as well as its expertise in operations and manufacturing. This partnership and joint venture will help GNC capitalize on China’s growing demand for nutritional supplements.

The Health Supplement Industry

The global dietary supplements market is being driven by increasing awareness on the part of the consumer, who is seeking preventative healthcare. In addition, it is also being driven by the growth of the aging population. According to a Zion Market Research report, the global dietary supplements market, valued at USD $132.8 billion in 2016, is expected to reach USD $220.3 billion in 2022 and is anticipated to grow at a compound annual growth rate of 8.8% between 2017 and 2022. In 2016, Asia Pacific made up the largest market for dietary supplements, accounting for more than 31% of the total volume of the dietary supplements market. This trend is anticipated to continue into the coming years. The second largest market was North America, with 28% of the total market. Most of the growth in the North American market is projected to come from products that are related to weight loss and weight maintenance.

Extending Debt Maturities

Along with the Harbin partnership, GNC also announced plans to extend the maturity date on its existing term loan facility which is currently due March 2019. The company seeks to extend this date to March 2021. In addition, GNC’s existing credit facility would be cancelled and it would enter into a new $100 million revolver. The company’s largest term loan lenders have indicated their support of this extension and new credit facility, conditioned upon the successful closing of the Hayao deal.

Liquidity and Interest Coverage

Interest coverage is of paramount importance to bondholders as it indicates a company’s ability to service its existing debt. GNC’s interest coverage ratio for Q1 is excellent. For the first quarter 2018, GNC had operating income of $46.4 million and interest expense of $21.8 million, giving the company an interest coverage ratio of 2.1x. In terms of liquidity, as of March 31, 2018, GNC had cash and cash equivalents of $53.9 million.

Risks

The risk of default on these convertible bonds is tied to both GNC’s continuing to refine its offerings as well as the outcome of the deal with Harbin. In terms of refining, the company has announced that it has plans to close 200 stores in 2018 in an effort to focus on locations that are doing well and eliminate those that are struggling. The company’s private label offerings are increasing as a percentage of sales, driving gross margins. The Harbin deal will definitely bring a boost to GNC, not only in the form of capital, but the joint venture will provide increased opportunities to grow the GNC brand in China. In light of these factors, the over 13.5% yield-to-maturity on GNC’s 2020 bonds appears to outweigh the risks identified.

Currently, GNC does not have a quorum from its shareholders to move forward with the deal with Harbin. Management believes it will ultimately have the necessary agreement level from current shareholders to move forward with the deal, but if they are not able to gain this, it could adversely affect the company, primarily through not being able to extend the maturity on its term loan, which is currently due in March 2019.

These bonds have a convertibility feature that allows bondholders to convert to common stock. Considering the recent stock price, the convertible feature on these bonds may not result in the possibility for increased returns. However, at present the yield to maturity is still very competitive.

In general, bond prices rise when interest rates fall and vice versa. This effect tends to be more pronounced for lower couponed, longer-term debt instruments. Any fixed income security sold or redeemed prior to maturity may be subject to a gain or loss. Higher yielding bonds typically have lower credit ratings, if any, and therefore involve higher degrees of risk and may not be suitable for all investors.

Summary and Conclusion

GNC posted a surprise for the analysts in its first quarter for 2018, beating targets for revenues and EPS. The company continues to create new product offerings for its customers, ultimately resulting in increased private label sales as percentage of total sales. Its most recent quarter saw increases in free cash flow and adjusted EBITDA year-over-year. There is healthy interest coverage for bondholders as well as a solid level of cash on hand to cover ongoing operating costs. The company has committed to using free cash flow to continue to pay down debt. When / if the Harbin deal closes, GNC will have a significant capital inflow that will help it pay down debt and increase cash on hand, as well as another mechanism to increase its sales in China. Considering these positive developments, GNC’s 2020 bonds, currently selling at a discount and with a yield-to-maturity of more than 13.5%, are ideal for additional weighting in Durig Capital’s Fixed Income 2 (FX2) Managed Income Portfolio.

Issuer: GNC Holdings
Ticker: NYSE:GNC
Price: $7.25 (as of 5/8/2017)
Conversion Price: $66.06/share
Coupon: 1.5%
Ratings: – / –
Maturity: 08/15/2020
Pays: Semi-Annually
Price: 77.0
Yield to Maturity: ~13.5%

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Disclosure: Durig Capital and certain clients may hold positions in GNC’s 2020 bonds.

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