The denouement of the GNC Holdings (GNC) debt saga, we predicted on the finish of 2017, would come sooner or later within the (then) coming 12 months. The prediction was a fait accompli – an inevitability – given the corporate’s debt maturities and the shortage of accessible sources, though we had thought of an outright acquisition of the corporate extra doubtless than the eventual fairness recapitalization. However, it hardly proved the top of the story because the decision of the debt scenario solely shifted focus onto questions concerning the persistency and strength of the underlying enterprise.
The 12 months has, regardless of being notable for eliminating the query of imminent chapter, been in any other case unfulfilling for shareholders. The constructive similar-retailer gross sales efficiency skilled on the finish of the prior 12 months petered out and the corporate hasn’t but been in a position to acquire important traction within the market. The prices related to refinancing the debt lowered the corporate’s potential to pay down important debt within the present 12 months. The firm’s administration has continued to unnecessarily overpromise and beneath-ship, doubtless in an effort to spice up clearly bitter sentiment, though we’d argue the online impact has been additional questions on administration’s forecasting credibility. In the meantime, the share worth continued to erode, falling beneath the underside of even our personal (supposedly conservative) valuation vary.
However, our view is that the monetary scenario and valuation have lastly reached some extent the place there’s a clearer rationale for the corporate than at any prior interval throughout our protection. The quick argument which has dominated sentiment (and been largely justified by the corporate’s outcomes) has basically run its course. The closing of the debt refinancing and most well-liked stock transaction have eradicated the potential for imminent chapter. The firm has begun shifting to aggressively cut back the shop base and enhance working margins. The China three way partnership will doubtless enhance lengthy-time period outcomes, nonetheless modestly, moreso than retaining the enterprise independently regardless of the doubtless quick-time period monetary influence. Finally, barring a sudden adverse shift in margins or similar-retailer gross sales, the corporate is positioned to start paying down debt utilizing free money flows at an affordable clip. It stays to be seen whether or not administration can enhance on its forecasting document, however regardless, the quick view has acknowledged these shifting attributes as mirrored within the lengthy decline within the firm’s excellent quick curiosity.
In this text, we talk about the declining quick curiosity, our view that the quick argument has doubtless largely run its course, and our perspective on approaches from a portfolio perspective. Finally, we word that though the debt scenario has been resolved in the intervening time, GNC’s work stays unfinished as the corporate should now deal with working efficiency when it comes to gross and working margins and similar-retailer gross sales outcomes. The rapid disaster related to the debt refinancing having handed, the onerous work of constructing the enterprise sustainable begins.
Persistent Decline in Short Interest
GNC’s quick curiosity has been in persistent decline for a lot of the 12 months, though it wouldn’t be obvious from the commentary usually offered on the corporate. The threats and admonitions assigned to only about any adverse worth motion within the firm (whatever the related information) is that the quick curiosity is pressuring the corporate’s shares. However, GNC’s quick curiosity most just lately peaked ten months in the past in February with over 30 million shares quick and has since declined nearly each quick curiosity reporting interval for a cumulative decline of greater than 10 million shares from the height. In the meantime, the share worth has declined some 40% from barely over $4.00 per share to lower than $2.50.
In essence, the favored argument seems to be that the nefarious shorts are onerous at work miserable the corporate’s valuation whereas concurrently overlaying thousands and thousands of shares over a interval of practically a 12 months. It’s fairly the feat of monetary engineering.
Of course, that is nonsense. The actuality is as an alternative that GNC’s enterprise stays challenged – similar-retailer gross sales proceed to be weak (although not catastrophically so), administration continues to commit unforced errors, and the corporate’s profitability has been hit onerous by the far larger curiosity expense incurred after the refinancing of the legacy time period loans. It’s not tough to see why sentiment is bitter. The concept that quick sellers are behind the sentiment locations the cart earlier than the horse – within the occasion GNC have been unequivocally sturdy, there could be no materials quick curiosity.
Clearly, some on the quick facet of the equation suppose there may be nonetheless worth to be rung out of the corporate’s depressed shares, though the decline within the quick curiosity suggests an rising quantity suppose the potential returns going ahead don’t justify the relative dangers.
We’ve argued simply this level earlier than and have been (if quickly) appropriate – the receipt of CFIUS approval of the popular stock transaction despatched the shares hovering shortly after our argument that GNC has turn into an more and more harmful quick place to carry, though the positive factors have been shortly dissipated by the corporate’s poor third-quarter efficiency. We, admittedly, concurrently dedicated our personal unforced error by not considerably lowering our quick put possibility positions on the rise in share worth. Regardless, quick curiosity within the firm is in persistent decline.
So, why is there nonetheless a big quick curiosity on the present valuation? Instead of viewing the corporate as a possible turnaround (or not less than able to sustaining important debt discount), the market is treating GNC equally to different retailers who’ve fallen on onerous occasions and whose shares commerce round a greenback or much less, akin to Christopher and Banks (CBK), Stein Mart (SMRT), Fred’s (FRED), Tuesday Morning (TUES), and Francesca’s (FRAN). The record goes on – there is no such thing as a scarcity of retail wreckage within the market. A brief place on the present valuation depends on an assumption of simply such an consequence for GNC – however whereas most of the above corporations have passing similarities, there may be typically a key distinction between these and GNC.
Specifically, whereas GNC actually faces challenges on the debt and retail fronts, the corporate to this point stays each worthwhile and extremely operationally money move generative (if not as a lot in order in prior years), whereas most of the above referenced corporations are both unprofitable and/or generate negligible or adverse money flows excluding working capital changes.
The quick argument at this level should thus shift from a easy decline within the firm’s working efficiency, which has confirmed correct over the past two to 3 years, to one among elementary operational failure, i.e., the inherent destruction of worth. The easy view that the corporate’s similar-retailer gross sales or margins will proceed to erode is now not ample to justify a brief place; as an alternative, it’s essential to imagine that very same-retailer gross sales – and thus free money flows obtainable for debt discount – will collapse on a scale much like the readjustments skilled two years in the past.
However, we don’t contemplate this a possible consequence. Possible, sure, however comparatively unlikely within the context of the corporate’s present scenario. In our monetary fashions, the identical-retailer gross sales and working margin assumptions required to justify valuations considerably beneath the present market worth (that’s, beneath $1.00 per share) or to significantly threaten the corporate’s potential to satisfy minimal required debt obligations fall outdoors of the ranges we contemplate fairly doubtless even on the pessimistic finish of the respective ranges. Our base case, which tasks declines over the subsequent two years in similar-retailer gross sales outcomes in addition to gross margins, is hardly an optimistic perspective.
Indeed, within the occasion the corporate merely manages to muddle alongside repaying debt with out important development within the enterprise, the compensation of $80 million a 12 months in excessive charge time period mortgage debt (plus or minus $10 million) ought to cut back curiosity expense by round $9 million a 12 months and enhance earnings per share by $0.08 on a statutory tax charge foundation – all of which is recurring and compounds 12 months after 12 months. In impact, the corporate might obtain one thing approaching 20% annual earnings development based mostly on present estimates just by guaranteeing the underlying enterprise doesn’t collapse. It’s a fairly low bar when it comes to expectations.
Granted, that’s small consolation for shareholders who’ve held the shares for an prolonged time period, nevertheless it does present a foundation for turn into extra constructive on the corporate’s prospects on the present valuation. In explicit, whereas we don’t place nice credence in making funding selections based mostly on tax associated anomalies since our focus is usually on the long run, it’s not inconceivable to imagine that some quick positions could properly wait till after the top of the calendar 12 months earlier than reserving taxable positive factors to not point out no matter marginal influence related to potential tax loss promoting earlier than the top of the 12 months.
In the general context, it’s due to this fact tough for us to see a justification for sustaining lengthy-time period quick curiosity positions on the present valuation.
In addition to the everyday boilerplate disclosures on the finish of the article, we really feel compelled to notice that since our final article now we have bought shares of the corporate within the open market to create a measured portfolio place.
In the previous, now we have argued for an choices based mostly method to the corporate’s shares based mostly on the idea that the shares have been undervalued however included a ample diploma of uncertainty with respect to the valuation that an choices based mostly method was extra favorable than outright possession of the shares. In essence, whereas our valuation mannequin recommended modest overvaluation to modest undervaluation (when our anticipated worth vary was $4.00-$8.00), it made extra sense to seize the numerous possibility premiums related to $2.50 and $5.00 put choices and reduce draw back danger.
In November a 12 months in the past, for instance, the corporate’s January 2019 $5.00 places might simply be offered for round $1.50-$1.75 per share with the shares buying and selling between $5.50 and $6.00. The potential upside in our valuation vary on the time was about $2.00-$2.50 – not rather more than the choice premium – however the draw back was between $1.50-$2.00. The possibility method allowed the potential to seize of considerably all the upside based mostly on our valuation mannequin whereas eliminating any danger of loss till the shares declined to not less than $3.50, beneath the underside finish of our valuation vary. The danger/reward steadiness was, in our view, significantly better weighted for an possibility place than a stock place.
However, the latest valuation is sufficiently modest, the vary of potential outcomes per our present valuation evaluation ($3.25 to $6.50 per share) sufficiently above the present market worth, and the obtainable lengthy-time period put possibility strike costs sufficiently restricted, that the above calculation has shifted in direction of outright buy. The danger/reward steadiness is now fairly higher suited to holding the shares fairly than shorting the put choices.
In one respect, the anticipated denouement got here to go. The solvency saga which outlined the prior 12 months was resolved via the mixture of an costly refinancing (much more so than we’d anticipated) and the popular stock transaction. The impending risk of chapter has largely handed and the main focus has since shifted from rapid liquidity issues to the continued weak spot within the underlying enterprise, particularly on the home entrance. The denouement of this second section – the lengthy-time period sustainability of the enterprise – won’t happen throughout the subsequent 12 months. Instead, whereas the approaching 12 months will present further info for constructing an extended-time period view on the corporate’s prospects, the decision will doubtless be measured not in months however in years. The firm’s adherents ought to put together for gradual and incremental progress throughout which the share worth could very properly stay largely stagnant for a time period.
However, we see few viable arguments to help the quick place on the present valuation barring a big acceleration within the deterioration of similar-retailer gross sales or gross margins. The firm’s outcomes on each metrics have actually not been sturdy however are additionally far in need of deteriorating to the purpose the place the corporate’s monetary viability could be unsure. In addition, the corporate can soak up further modest deterioration earlier than free money move would deteriorate to some extent the place debt would turn into a problem.
In essence, we imagine the quick argument has largely performed out and pessimism is close to a peak. The mixture of restricted potential positive factors from the present valuation, probably important losses, and relative likelihood that the corporate will be capable of not less than muddle alongside whereas repaying important debt (thus, at worst, justifying the present valuation) strongly argues for a continued incremental closing (and even accelerated closing) of current quick positions. The working assumptions required to yield additional significant quick place positive factors strike us as aggressively pessimistic.
GNC stays speculative with a lot work forward for the corporate. However, the present valuation most likely displays a great deal of that uncertainty and should present the chance – in the long run – lengthy awaited by the corporate’s ardent adherents.
Disclosure: I’m/we’re lengthy GNC. I wrote this text myself, and it expresses my very own opinions. I’m not receiving compensation for it (apart from from Seeking Alpha). I’ve no enterprise relationship with any firm whose stock is talked about on this article.
Additional disclosure: In addition, we’re successfully lengthy via quick put possibility positions.