Can you find a market leader in a non-cyclical industry that trades for under 10x forward EPS? Here's one: GNC.

GNC is the market leader with sales of $2.6 B in a ~$37 B U.S. dietary supplement market (which has historically grown in the mid-single digits each year for many years). For the last quarter, GNC's ROIC was 13.5% and EBIT margin was an impressive16.2%.

GNC is also cheap. The stock has been recently setting new 52-week lows and is down almost 50% from its high. Annualizing the recent quarter, fully-taxed earnings yield  is 9.0%. Taking the mid-point of company's 2014 guidance (May 6, 2014), earnings yield is 9.2%. Taking 2015 consensus estimates, earnings yield is 10.4%.

CONCERNS and RISKS

Let's start with some of the negatives.

Retail/ U.S. operations are mature/maturing...

"Retail" makes up the significant majority of company sales (73% of 2013 sales) and includes company-owned stores in the U.S., Canada, Puerto Rico as well as company websites. This "retail" or U.S. operations portion is arguably mature. GNC already has over 6,600 U.S./Canada locations (including franchises and store-within-a-store locations at Rite Aid). GNC is already in every state and has 279 locations in CA, 264 in FL, 221 in Texas, 201 in NY, etc.

and U.S. franchises are mature/maturing...

Franchise sales were 17% of 2013 sales. In addition to 3,378 company-owned locations, GNC has 5,300 franchised locations (1,026 U.S., 2,051 International, 2,223 Rite Aid store-within-a-store) for a total of 8,678 stores. As background, U.S. franchise locations are typically 1,000-2,000 square feet and 90% are in strip malls and shopping centers. GNC had a 95% domestic renewal rate on franchises between 2008 and 2013. Largest franchisee owns 19 stores. Franchises pay upfront $40,000 and then 6% royalty on sales and 3% of sales for national advertising fund. A look at GNC's corporate website reveals only 50 franchise opportunities available across the U.S.! Meanwhile, Rite Aid is adding some more locations (about 50 a year from 2014 to 2019) but represented only 3% of total sales in 2013 (which is unlikely to go higher).

while Internet competition is increasing.

Earlier this month, Kroger announced it is acquiring Vitacost.com for $280 m to accelerate e-commerce operations. Furthermore, it has been widely reported that third-party sellers are buying discounted products at GNC.com and then re-selling them on Amazon to such an extent that Amazon now lists most of GNC's 1,800 SKUs. GNC also faces increasing competition (especially online) from Vitamin Shoppe (VSI), its largest direct competitor, which has over $1.2 B in sales.

Recent results (1Q14) were weak y/y...

Franchise sales and wholesale sales (to Rite Aid, Sam's Club, PetSmart, drugstore.com; 10% of 2013 sales) had modest declines y/y in the recent quarter. As a sign of increasing Internet competition, gross profit decreased 0.1% to $256 m and gross margin contracted 70 bp to 37.8%. Similarly, Vitamin Shoppe (VSI) had a gross margin contraction of 80 bp to 35.6%. Overall, GNC's NI was down y/y last quarter, from $72.6 m to $69.9 m; however, EPS was up from $0.73 to $0.75 due to fewer outstanding shares.

while net debt has grown considerably.

Long-term debt of $1.3 B as of 3/31/14, up from $1.1 B at end of 2012. The "Term Loan Facility" allows borrowings of $1.65 B and matures in March 2019. The interest rate was 3.25% at December 2013 and March 2014.

OUTLOOK

Despite these concerns (maturing U.S., Internet competition, recent weakness y/y and the increase in debt), the company has a strong position in a non-cyclical industry and the stock is now cheap (due to growth investors piling out after the recent weak quarter), especially with the company aggressively repurchasing shares.

Historical growth is impressive

There has been recent weakness y/y because GNC faces difficult comparisons in 2014 (e.g. Gold Card program was expanded nationally in 2013). It's helpful to take a step back and look at GNC's five-year results, which are impressive. Over the last five years (2009 to 2013), the company has steadily posted stronger sales, EBIT, NI, EPS, CFO:

Sales up from $1.7 B to $2.6 B.

GP up from $591 m to $993 m.

EBIT up from $181 m to $461 m.

NI up from $70 m to $265 m.

EPS up from $0.58 to $2.75.

CFO up from $114 m to $238 m.

Company owned stores up from 2,774 to 3,342.

Total stores up from 6,917 to 8,593.

While GNC won't grow at the historical rate, there is growth potential, particularly in new geographies for international franchisees: Europe, Brazil, China, Russia, South Africa. International franchisees pay $25k for a franchise license and then varying royalty fees (usually less than 6% royalty rate in U.S.). International franchise locations have grown from 1,188 at the end of 2008 to 2,024 at the end of 2013.

Moreover, GNC has potential to significantly grow its e-commerce sites. GNC.com sales were up 26.6% in 2013 and 21.6% in 1Q14. In 1Q14, LuckyVitamin.com (acquired in August 2011 for $19.8 m) contributed $2.2 m in sales. In 1Q14, DiscountSupplements.com (acquired October 2013 for $33.3 m) contributed $8.6 m.

Also, GNC is positioned to benefit from historical growth in several health categories. GNC's U.S. retail sales are spread across several categories: 44% sports nutrition, 39% VMHS (vitamins, minerals, herbal supplements), 12% diet products, 5% other wellness products. These health categories will continue to grow over time.

while maintaining industry-leading margins.

As mentioned, for the last quarter, GNC's ROIC was 13.5% and EBIT margin was an impressive16.2%. Gross margin is helped by private label products. About 54% of company sales are private label. Private label products are manufactured in facilities in South Carolina. Except for powders and liquids, these facilities produce nearly all GNC's proprietary products.

In addition to private label, the industry-leading margins may also be due to the Gold Card program (yeah, I've been a member). Gold Card members - 8.3 million in U.S. and Canada - account for over 75% of company-owned retail sales and spend about 2x more than other GNC customers. Gold Card members pay $15 in membership a year and get 10-50% discounts. Gold Card members was expanded nationwide in 2013 and may have caused the difficult comparisons for 2014.

Other reasons for the higher margins could be GNC's brand, the convenience (due to many locations), better trained employees and staff (who are often paid partly on commission) and economies of scale as the largest operator with vertical operations.

Recently, the company has been aggressively repurchasing stock.

In 2013, GNC repurchased $310.6 m in stock. In late November 2013, the board authorized a two-year $500 m share repurchase program. In 1Q14, GNC generated CFO of $123.1 m with capex of $12.8 m, repurchased $150 m in common stock and paid $14.6 m in dividends. Share count is now 90.9 mi, down nicely from 99.2 m at the end of 2012.

which makes the stock increasingly cheap even if NI is flat going forward.

In 1Q14, FCF (defined as cash provided by operations less cash used in investing activities excluding acquisitions) was $109.7 m. Annualized, that's $438.6 m, or 15% of the company's market cap. Even if results are flat going forward (highly unlikely due to franchise growth and internet growth, as well as industry growth), GNC could repurchase ~10% of its market cap annually, driving EPS up 10% each year. Guidance (last updated May 6, 2014): EPS of $3.05 to $3.1 for 2014 (up 7-9% over F13 adjusted EPS of $2.85).

GNC also pays a modest dividend, $0.44 in 2012, $0.60 in 2013 and  $0.64 in 2014E.

VALUATION

GNC arguably deserves a market multiple, especially as it is the market leader in this category. By comparison, smaller Vitamin Shoppe (VSI) trades at market-multiples of 17.6x F14 EPS and 15.1x F15 EPS. A 15x F14 EPS of $3.07 puts GNC at $46.05 (+38%). With continued share repurchases (and without any growth from franchises, Internet sales, retail and without any growth in the industry), EPS should rise to $3.5 to $4 over the next 2-3 years. A 15x multiple of EPS would put the stock at $52.5-60 (+57% to +79%). Plus any dividends. Plus any organic growth.

As a check, GNC IPO'd in April 2011 for $16 per share. At the time of the IPO, F10 EPS was $0.85, and F11 EPS was $1.24, so the stock IPO'd for 18.8x TTM EPS and 12.9x forward EPS. Today, 18.8x TTM EPS of $2.75 (F13) would put the stock at $51.7 (+55%) and 12.9x forward EPS (F14) of $3.07 would put the stock at $39.6 (+19%) and 12.9x forward EPS (F15) of $3.47 would put the stock at $44.7 (+34%).  

Modest growth resumes (from franchises, retail/Internet sales and/or industry)

Cheap valuation, especially for a market leader

Continued share repurchases drive EPS growth, making the stock even cheaper