Vitacost.com Is A Compelling Risk/Reward Before Earnings

Executive summary:

• Vitacost.com (VITC) ("Vitacost") is cheap both on an absolute and relative basis.


• Certain activist investors are calling for the company to sell itself.


• Vitacost reports full year 2013 results before the bell on Thursday, February 27, which could act as a positive catalyst to move the shares higher.

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Vitacost is an online retailer of vitamins, minerals, health supplements, beauty products and natural foods. Vitacost carries over 40,000 SKUs across these product categories, as seen below.

(click to enlarge)

source: Vitacost investor presentation

At Vitacost's current $207 million valuation, the shares are providing for a particularly asymmetric investment given the low valuation (0.5x EV/sales) and recent insider shareholder activism calling for the sale of the company.

In my view, the earnings report on Thursday will be a positive catalyst to push Vitacost shares higher because the market is not pricing rosy expectations in the shares. Vitacost shares sold off in November due to missing analyst expectations. In Q3, Vitacost grew sales to $90.5 million, 10% year-over-year (down 7% sequentially). Historically, Vitacost grew sales at a 27% compound annual growth rate ("CAGR") from 2007 through 2012.

(click to enlarge)

source: Vitacost investor presentation

To account for the sales "miss," CEO Jeffery Horowitz (Founder and former CEO of Vitamin Shoppe) made these comments on the last conference call (transcript courtesy of Seeking Alpha):

As we mentioned on our last call, this quarter we began testing new promotional strategies in order to better balance customer growth and gross margin. Accordingly, in August, we reduced the number of broad-based sideway sales often on our website and focused on more targeted promotional campaigns to improve the quality of our customer base.

In addition, we also refined our sales and marketing strategy to focus on the highest returning channels and reduce spending on low-performing keywords. While these efforts had a positive impact and reduced our EBITDA loss by $1.9 million year-over-year we are continuing to refine our online advertising and test new commercial strategies to better balance customer acquisition, retention and top line growth with margin dollars.

While our third quarter revenue growth was below historical levels, we have several new marketing initiatives underway which we feel strongly support our long-time growth objectives. First, as many of you know, the bulk of current advertising affects our online primarily through keyword buys and affiliates. This has been an effective use spending to target customers already shopping online to introduce them to our website and proprietary brand.

However, we also believe there is a large opportunity to target a broader customer base in other channels and educate them about the value of Vitacost.com through the use of broad-based media as only an estimated 5% of our target market is currently shopping online. Therefore, we are actively working to launch a broad-based media campaign in the first half 2014. We believe this will significantly increase our Company and brand awareness and capture new customers unaware of Vitacost and our strong value proposition.

I view the slower growth in Q3 as a short-term aberration, primarily due to slight changes to marketing efforts outlined by management. Management added 220,000 active customers to the company's base (including me), bringing the count to 2.1 million active customers. By bringing some of the marketing spend to television and print ads, I believe that Vitacost will increase brand awareness among its target market.

Meanwhile, the vitamins and supplements sector remains a growth industry. The Nutrition Business Journal ("NBJ") is forecasting the total US nutrition and dietary supplement industries to grow at 8% and 7% through 2020, respectively. However, it expects the eCommerce sales channel to grow at 13% over a comparative time frame. To that end, Vitacost is a pure play on the faster growing eCommerce segment, and has a much bigger eCommerce business than GNC (GNC) or Vitamin Shoppe (VSI). In the most recent quarter, Vitamin Shoppe reported eCommerce sales up 25.5% (or 20% excluding inorganic growth from its recent acquisition, Super Supplements). GNC doesn't break out eCommerce sales given it is a de minimis part of its business currently, although it is actively seeking to grow this channel via gnc.com and luckyvitamin.com (a business it acquired in 2011).

After reviewing the GNC and Vitamin Shoppe earnings releases and conference calls, it is clear physical retail continues to be a challenge. GNC blamed extreme weather conditions, a problem Vitacost doesn't have given it is an eCommerce only enterprise.

Putting it together, I think Vitacost's sales will retrace back to management's long-term revenue growth guidance of between 15 and 20%, which should bring 2013 year-end sales to about $380 to $400 million.

Valuation

Assuming $400 million in full year 2013 sales, Vitacost currently trades at about 0.5x EV/Sales, far lower than GNC (2.1x) or Vitamin Shoppe (1.2x). However, Vitacost is growing at a much faster pace and has a less capital intensive operating model.

What about profits? No, Vitacost is not profitable yet. But it continues to scale and its operating model provides for attractive economics given the low capex requirements and small amount of working capital needed to operate this business. At scale, Vitacost is guiding to a 6 to 10% EBITDA margins, which, in my view, is quite achievable, and should eventually lead to 2 to 3% free cash flow margin. Given the low capital requirements, even 2 to 3% free cash flow margins will lead to high returns on invested capital.

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source: Vitacost investor presentation

So what is this business worth? I looked at the valuation from three lenses: (1) a sales multiple; (2) a pro forma EBITDA multiple; and (3) a discounted cash flow analysis.

For an eCommerce business, I think 1x sales is appropriate given the target operating model and growth trajectory. While Zappos is not a perfect comparable for Vitacost, Amazon (AMZN) acquired the online shoe retailer for about 1x sales in 2009. While we are comparing different products, we are comparing similar operating models (eCommerce) and management philosophies (intense focus on the customer). In fact, Vitacost ranks behind only Amazon for customer satisfaction. [Note: I think Vitacost would be an ideal acquisition target for Amazon, or GNC or Vitamin Shoppe for that matter (discussed below).] Although the Zappos deal is now stale, I would suggest the 1x sales multiple is conservative in today's ebullient market conditions (relative to the market conditions in 2009). 1x sales suggests $400 million, or $12 per share.

Another way to value Vitacost is to estimate pro forma EBITDA margins based on the target operating model. Using an 8% EBITDA margin suggests $32 million pro forma EBITDA. GNC and Vitamin Shoppe trade between 9 and 10x EV/EBITDA. Applying a 10x multiple to pro forma EBITDA and adding $20 million in net cash suggests $340 million, or $10 per share.

Lastly, I modeled out a discounted cash flow analysis using management's assumptions. Using a 12% discount rate and a 5% terminal growth rate, my DCF model indicates $11/share fair value. If, however, I model less robust (10%) growth and a 3% terminal growth rate, my DCF indicates $5/share. Given the industry dynamics, I think this is a very low probability and provides a floor in the share price.

Any way I slice it, Vitacost looks cheap both on an absolute and relative basis. While Vitacost is yet to be profitable, it has the potential to be a significantly better business than GNC or Vitamin Shoppe at scale.

If we look at inventory turns, we find out why. Vitacost is a far more efficient business, and it has been supporting 25%+ revenue growth over the last several years with relatively the same inventory requirements. Inventory has fluctuated between $28 and $34 million over the last several years.

VITC Inventory Turnover (Annual) data by YCharts

Similarly, Vitacost employs far less working capital and turns it over much faster than GNC or Vitamin Shoppe.

VITC Working Capital Turnover (Annual) data by YCharts

And finally, Vitacost converts inputs into cash at a much higher pace.

VITC Cash Conversion Cycle (Annual) data by YCharts

Vitacost is a far more capital efficient business than either GNC or Vitamin Shoppe. For that reason, I think Vitacost shares are presenting a compelling risk/reward investment headed into earnings on February 27, especially now that downside appears to be reduced after recent revelations of large shareholders turning activist.

Downside Risk Muted - Shareholder Activists

Vitacost picked up a unique catalyst late last week when a large 7.7% shareholder, Ryan Drexler, turned activist and urged Vitacost to explore a sale of the business to a better capitalized, strategic buyer. Mr. Drexler is intimately familiar with the vitamin and dietary supplement business, having negotiated the sale of his family's business, Country Life Vitamins, to Kikkoman in 2005.

In addition, Osmium Partners, who owns 8.2% of Vitacost, recently filed a 13D on February 7 with the intention to nominate two new board members in the upcoming annual meeting.

Given that shareholders representing ~15% of the equity recently filed 13Ds, that should minimize downside risk as investors contemplate some sort of transaction to unlock value. After news of Mr. Drexler's filing, shares climbed 13%. I think the $5.50 price pre-announcement serves as a psychological floor in the stock price (and because it represents only 0.4x EV/Sales), while I estimate intrinsic value to be $10 - $12 per share, or between 60 to 90% upside from here.

Conclusion

Vitacost certainly appears like a compelling risk/reward investment given the recent news that large investors are pushing for a sale of the business and/or board nominations; meanwhile, the business looks undervalued on a variety of valuation measures. While competition is a threat to the investment thesis (as it always is), I think the fact that Vitacost does not have exposure to physical retail is a benefit, especially since the online sales channel is expected to grow at a much faster pace (and better operating model dynamics). Vitamin Shoppe's recent earnings release provides some evidence to the eCommerce opportunity, as it grew digital sales at 25% year-over-year.

Given GNC and Vitamin Shoppe have a much smaller presence online, I believe Vitacost is a compelling acquisition candidate. Even if Vitacost isn't taken out, I think there is substantial value on a standalone basis.

Source: Vitacost.com Is A Compelling Risk/Reward Before Earnings

Disclosure: I am long VITC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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