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Avram Fisher, Founder & Portfolio Manager of Long Cast Advisers, is a former equity analyst at CSFB and BMO covering industrials and business services. He has prior experience in private equity; as a corporate governance analyst; as a writer; reporter and private investigator; and as a lifeguard and busboy (I still clear plates when my kids don't). This blog is an open book of ideas about patient investing and about starting up a small-cap focused RIA. It is part decision-diary, part investment observations and part general musings. Nothing on this blog is a solicitation for business nor a recommendation to buy or sell securities. It is simply a way to organize and share thoughts with an expanding audience of independent, patient and talented small cap investors. www.longcastadvisers.com

Monday, August 31, 2015

$FTLF: A good business with good mgmt, but how does a bias against a product fit with investing?

Fitlife Brands - $FTLF - came across my radar at the IDEAS conference in Boston in June. Since that conference, I've researched the stock, built the model, and have spent an inordinate amount of time thinking about the company and the industry.

The company, at the current price of $1.70, is valued at 6.5x proforma EBITDA but I see an avenue towards $2.60 / share for the stock. During a prior growth phase (2013-2014), it traded at 10x EBITDA and if it goes back to those levels - comps get easier in the back half of the year - that's the pathway to 50% upside. Furthermore, the company is well run, well managed, is profitable and generates cash.






On the downside, I calculate balance sheet liquidation at $0.70 / share; that's simply working capital less net debt, a best case scenario for what happens if the doors close tomorrow.

But buried in working capital is a deferred tax asset of $6.5M, representing the tax adjusted value of $19M in NOL's. That DTA is offset by a substantial $5.8M valuation allowance but if the company continues its profitability and the valuation allowance goes away, you could say that about 30% of the proforma market cap is in that deferred tax asset. That DTA fully valued is worth another $0.70 / share, bringing the downside to $1.40. I think the market tends towards simpler multiples and on that end, the company has traded as low as 5x, which infers $1.30 / share downside.

All these attributes make the company a potentially interesting investment - 50% upside vs 25% downside - but the industry also presents it's own characteristics that bear on the company's valuation. It is fragmented, competitive, with low barriers to entry, and endures the vagabond nature of consumer tastes, government regulations and media ridicule. Sometimes it is in fashion and sometimes it is out; currently it is out of favor in all three areas.

Qualitatively, I'm not totally comfortable with the company or the industry. I don't look kindly on the pills and powders market. I don't use "five hour energy" drink. I don't drink red bull. So while I try to keep my financial judgement independent from my emotions, my entire view of this thesis is clouded by my intuition that I do not want to invest in snake oil a product that concerns me [i've since conducted a small sample of channel checks and the feedback from sales people on the product is positive >> http://goo.gl/d130zS].

I keep circling around these two mutually exclusive issues. On one hand the value of a well run business that generates cash and on another an industry that repels me. My hope is that writing this helps to frame the broader question about what my goals are as an investor, b/c the qualitative aspects do (and I think should) overlap with the financial. It's part of who I am as an investor and I don't want that to change. I'm hoping that this writing helps me come to a conclusion. (I bought a few shares to see if I was comfortable with it and my head hasn't exploded ... yet).

I'll start with the  core business.  At the moment, FTLF is an OTC listed / SEC filing $12M mkt cap company that makes branded sports nutritional supplements. These are pills and powders for "getting ripped" (maximizing workouts or accelerating recovery) and "meal replacement" (losing weight).

According to their investment presentation (i'm rounding), ~70% of the business is sports related and ~30% diet related plus a small ~5% "other" health / inflammation / vitality. Here's the latest presentation ...

http://www.sec.gov/Archives/edgar/data/1374328/000141588915002907/ex99-2.htm

... But that's all backward looking stuff.

Looking ahead, the company is in transition. Two things are changing ...

1) it's acquiring a competitor called iSatori for ~$7M, using 4M shares of stock on top of the existing 8M. (~50% dilution). The acquisition will double revenues. (That's ~0% growth of per share revenues by the way). However, after the deal, company will buy back at least 0.6M shares and up to 1.4M shares.

2) distribution channel is changing materially. Where it used to sell direct to GNC franchise stores (ie direct to individual stores paid for directly by the franchisee) now they've gotten so big, GNC is making them sell into a centralized distribution channel for re-distribution to franchise stores. Since GNC makes it's money selling wholesale to franchisees, I view this sort of like the mafia trying to take a cut on sales.

... as a result of these two changes the future looks different than the past. I summarize the combined proforma "back of the envelope" baseline of what the company looks like after the iSatori acquisition. Note that this proforma drives my above noted valuation:

$30M rev and 10% EBITDA margin business.
12M shares out after the deal
~.1$1M in net cash.
hence, ~$20M EV  business, $3M EBITDA = 6.5x multiple.

From a baseline of $30M in revenues, I think short term operating success looks like $40M in revenues and 10% margins. That means growing sales ~25% from here.

Looking back historically, from 2011 to 2014, mgmt grew sales 18% CAGR and shareholder equity 28% CAGR. And they nearly doubled my estimate for revenue / customers. These are substantial growth rates ...





... can they do that going forward?

I realize the 1H vs 1H comps suck, notably: Revenues down, margins down and DSO's up. These are initial artifacts of the transition in the GNC distribution system notably:

i) ahead of the wholesale transition, franchises stocked shelves, leading to revenue bubble and falloff.
ii) meanwhile the shift towards GNC wholesale distribution lead to longer DSO's b/c big corporate can pay when it wants.
iii) though they get paid later, there are no more credit card fees charged as a reduction in sales (when they sold direct to franchises they were typically paid by c/c).
iv) mgmt believes that net / net margins will not change but I anticipate some slippage and 10% EBITDA drives my back of the envelope assumption

... Obviously, given the 1H15 vs 1H14 comps, changes in the distribution channel - the "GNC mafia" - these are all headwinds the company needs to do something.

Adding new brands, new doors and new customers from this iSatori acquisition might help.  Can't fault them for trying. Change is part of business. They are not standing still. Kudos to a management team that adjusts, evolves and adapts, I can say that for sure! But the acquisition isn't so simple, and I'll discuss this a bit more later.

So what's it worth here? On a core basis, it's trading for 14x trailing TTM EBITDA but core is irrelevant due to the aforementioned changes. It's trading at 6.5x proforma EBITDA (assuming $30M sales / 10% EBITDA margins).

In 2013 and 2014 it traded around 10x trailing EBITDA. If it trades at 10x against a baseline $3M in EBITDA, this is a $2.60 stock. Even if it never grows, a revaluation based on acquired income leads to a 50% return in a years time. Are the micro-cap markets that inefficient that it can't see through the coming change? It's certainly not the only thesis.

Or maybe it can trade as low as 5x EBITDA? That infers $1.30 / share. Or the aforementioned $1.40 in balance sheet value, when considering the $19M NOL / $6.5M DTA?



Making decisions is hard. What else do we need to know about the company to help define the options?

The product. FTLF uses contract manufactures to make various formulations of its pills and dry powders. The company packages and brand and puts the product on store shelves, primarily in GNC franchise and corporate stores, and makes a margin there. The business is driven by new brands, new "doors" and same store sales.

The products are generally comprised of caffeine + extracts of various plants and herbs and / or their active derivatives that act as stimulants, appetite suppressants that increase /decrease blood pressure and/or blood flow and help alertness, appetite control, energy, etc.

It sells these products under five brands ...

Three brands - NDS, PMD and SirenLabs - are sold almost exclusively through GNC franchise stores.
MetisNutrition - recently launched and sold exclusively through GNC corporate stores.
CoreActive - the smallest brand - sold through independent channels.

... As you can see, the business is heavily reliant on GNC for distribution.

Here is the label of ONE of their SirenLabs diet pills the "Neuro Lean" ...

http://www.gnc.com/graphics/product_images/pGNC1-18884757_gnclabel_pdf.pdf

... amplify that a little bit and you'll see, below the main ingredient anydrous caffeine (ie its powdered form) other ingredients ...

Beta Phenylethylamine HCL - A central nervous system stimulant that boosts metabolism and is similar to caffeine but helps burns calories.

ADVANTRA Z - Also known as "Bitter Orange”. It's an appetite suppressant and stimulant that includes Synephrine, which is a powerful stimulant. This product is manufactured by NutraTech >> http://goo.gl/jOeF7a

NELULEAN - Extract of the Nelumbo Nucifera plant (aka "lotus"). Here's a little pdf on the product >> http://goo.gl/gVwust << but the company that makes it is "IN ingredients" >> http://goo.gl/AyIc31 <<

ALPHA YOHIMBINE - Opens blood vessels and improves blood flow which may aid in weight loss.

... and that's just in the "B.A.D. Fat Annihilation  Blend".

Alert 1: I really don't like these products. I'm sort of disgusted by it. If my kids used it, I'd probably sit them down and talk with them about their dangers, lack of regulation, etc. It gets back to the question, do I want to invest in a product that seems to me like "snake oil" whose value to the customer I really don't understand?

My disposition against the product might be a hurdle to my investing in the company. Is that crazy talk for an investor? I think it's a bias based on availability of information and personal belief. I mean, I've never seen anyone in a GNC store but the company does $1B in gross profit, $500M in OpInc and $260M in annual net income, so I should trust that info, right? And it can't be all bad if people use it?

Putting aside my external feelings, two things make the company unique ...  

1. FTLF is run by business people. The CEO John Wilson worked for $KO and the CFO Mike Abrams is a former investment banker at HC Wainwright and Burnham Hill.

Having spent some time researching its large competitor MusclePharm ($MSLP) and the soon to be acquired iSatori (IFIT), both of which are managed by athletes and weightlifters, the benefit of having business minds behind the enterprise can't be understated.

2. The company spends less than its peers on sales / marketing. Competitors (including iSatori) use expensive endorsements or meaty pitchmen to sell their products. FTLF instead goes to the franchisee and sells a copycat of a highly advertised competitor that generates a higher margin for the franchisee.

On one hand, it's a brilliant strategy to essentially outsource the advertising and capture the customer in the store. On the other hand, it can be a temporary advantage and potentially a race to the bottom.

... considering these characteristics, we have a low capital intensity / high variable cost business and it has the potential for high returns if the brands catch on with consumers, the product sells and overhead costs are kept low. These are some raw ingredients for a pretty good - not great - but pretty good business. 

Alert #2: What makes it unique also creates potential issues with the acquisition. iSatori is run by a muscleman, not a businessman. It advertises via paid endorsements. It has a much higher percentage of S&M / revenues than FTLF (24% for IFIT vs 12% for FTLF).

To add to the potential for executive tension, the CEO of IFIT (Stephen Adele) and its largest shareholder (Russell Cleveland) will together be the largest shareholders of the combined company with 32% of the outstanding shares after the deal.

In order to reduce this imbalance in ownership, after the deal closes in 3Q or 4Q15, FTLF has ...
i) an option to purchase 570k shares back from Adele and
ii) the right of first refusal on 800k shares of stock to be owned by Cleveland
... assuming the option is triggered with Adele at current prices $1.70, it would cost the company $1M to acquire the shares and reduce the share count to 11.5M. It's unclear what will happen to the shares held by Cleveland or who will buy them.

These slightly complicated post-deal repurchases are actually good for investors by reducing sharecount but the wider concern of mine is the risk of tension in the mgmt suite given the differences in operating styles. 

One tidbit offsets my fears about the acquisition. According to the S-4 IFIT's interim-CFO Seth Yakatan who is helping to negotiate and move the deal forward is taking all stock - no cash - as comp for his work. He's betting on the company.

The trick will be growing doors and revenues. This brings us back to the GNC angle

1. GNC franchise stores are already pretty well saturated. The company sells to 1,400 GNC franchise locations in the US and overseas. GNC has only 1,100 franchise locations in the US (and about 2,000 interationally). So they're pretty well penetrated in the domestic GNC channel.

Therefore, the key new channels are from international growth (which faces a headwind from f/x), iSatori (we don't really know how they're going to use that channel), and the new Metis line that will sell into GNC corporate stores, which are currently under-penetrated. According to FTLF's, presentation they add new brands every six months.

2. Also, as a tailwind, GNC is increasing its emphasis towards franchise stores. So that should make available new doors into an already deeply penetrated market.

Given the company's success in the past selling direct to GNC franchisees, I anticipate that it should be able to penetrate independent stores available to them in the IFIT channel. 

Alert #3, competition, et al. FTLF hasn't hit on a totally new business model - lots of companies use contract manufacturers - and their's isn't the only one with good management.

Also, competition in the industry is fierce. Here's the boilerplate from MSLP's 10K, which says it better than I do: "The nutritional supplements market is very competitive and the range of products is diverse. Competitors use price, efficacy claims, customer service, name recognition, trade relationships and new product innovation to create share of market.

Our range of competitors includes numerous nutritional supplement companies that are highly fragmented in terms of geographic market coverage, distribution channels and product categories.

In addition, large pharmaceutical companies and packaged food and beverage companies compete with us in the nutritional supplement market. Many of these companies have greater financial and distribution resources available to them than MusclePharm and many of these companies can compete through vertical integration.

Private label entities have gained a foothold in many nutrition categories and are direct competitors. A few of these are private label entities have become market leaders. In this industry, most of the companies are privately held.

With respect to retailer sales, we cannot fully gauge their sizes and our relative ranking. The world of nutritional supplements is constantly changing and we believe that retailers look to partner with suppliers who demonstrate financial stability, brand awareness, market intelligence, customer service and science. With this in mind, we believe we are competitive in all of these areas."

It's a mouthful, but worth reading twice. $MSLP is a much larger $65M mkt cap company managed by traditional industry leaders (muscle men not business men) best evidenced by their perennially negative returns, cash flow burn and especially the amateur way they published earnings followed two weeks later by a major restructuring announcement. The stock has lost 70% of its value over the last year. On an EV / revenue basis this unprofitable cash flow burning company in restructuring mode trades at roughly the same multiple as FTLF's proforma figures.

Interestingly, $MSLP's recently hired Bill Phillips as a "strategic adviser". Bill was Stephen Adele's boss at EAS before Adele started iSatori. This is an incestuous business.

Media ridicule = the "Post-Oz" era. See this January 2015 interview with Adele regarding the "state of the industry" and the headline noise >> http://goo.gl/z6oxq3 << I appreciate his intellectual honesty on all the bad news in play.

But as a comp for what "success" looks like, in June 2015, WhiteWave $WWAV acquired prvtly held Vega for 5x revenues ...

http://goo.gl/Qahmao

... good management and having the right product can create such outliers.

An option on "success mode". When you start to think about the baseline business $30M revenues / $3M EBITDA, what multiple to put on it, the value of the NOL's, etc. we haven't even broached the possibility of "success mode" that looks like Vega in the future. B/c as a branded consumer product that uses 3rd party contract manufacturing, it could have high returns IF it attracts a loyal customer base.

Admittedly, that's a huge "IF": Every consumer product aims for "that thing" that leads to love and loyalty, few reach it and none can predict it. Here, at the very least, you're not paying for success mode.

So what is all this worth? To summarize the observations so far:

1) It seems to have a VERY talented management team focused on profit and cash flow
2) It is deeply penetrated into it's leading distribution channel - GNC franchise stores - and GNC is expanding its franchise stores.
3) However, GNC has changed the way FTLF sell to the stores and this is (temporarily?) disrupting revenues and (temporarily?) weighing on the valuation.
4) It is acquiring a competitor (iSatori / $IFIT) that offers additional brands and distribution channels. The additional "retail brands" and "retail doors" are both positives
5) But IFIT manages and markets itself completely differently from core FTLF. The differences in management styles, creates the possibility for turbulence, a negative.
6) There's a big NOL that doesn't seem to be properly valued
7) The pills and powders industry makes me a little uncomfortable as a consumer and is itself undergoing a bit of a regulatory transition and "headline noise".

I think I conclude that FTLF is a pretty well run business, it solves a less than obvious problem for the franchisee and at 6x proforma EBITDA "success mode" is simply an option.

It has an opportunity to open new doors, new brands and generate growth and cash flow. It has grown revenues +15% CAGR in the past. I think those line up as a good opportunity. Plus, there's an avenue for a revaluation to 10x EBITDA. But I would need to either hold my nose or find a way to rationalize my external / unrelated bias against the product in order to make this a substantial investment.

Completely tangential moment as conclusion. This is the 30th anniversary of the release of the album Born to Run. I remember exactly when I got the album: I won it at Phillip Josephs's bar mitzvah, which happened to fall on my birthday! I had no idea of its' value - hadn't yet heard of the Boss - but when the older kids offered to buy it from me for $20, I knew it was worth something, so I kept it. Played it all the time. I still have it. Years later, I married a Springsteen fan, so maybe all these things come together.

I mention all this not just b/c it's a great album, and it's his 3rd album by the way, and very different from the first two and they are all great, but b/c the way I acquired it - and kept it - which is relevant to stock market investing. It's almost an innate experience to sense something's value when other's desire it and want to pay more for it. Even a kid can recognize this. It's harder to know the value when no one wants to pay a premium for it. That's an important point, I think, when it comes to investing.

-- END --

All rights reserved and copyrighted by Long Cast Advisers, LLC. This is not a solicitation for business or a recommendation to buy or sell securities. I own shares of FTLF. 

Saturday, August 29, 2015

$ARIS: Letter to the CEO & Board on the destructive impact of share dilution

I sent this August 11, 2015 to the CEO, CFO and the Board. There's a cautionary tale on the impact of dilution that isn't specific to micro caps caps but effects them greatly simply due to smaller shares outstanding. 

I wonder if capital allocation is something executives figure out and improve on over time? My general view is that people tend to not look constructively on their own behavior and therefore tend to not change their behavior, but I hope in this case they do. 

Dear Roy –

It’s an exciting time to be an ARIS shareholder.

I’m writing to you to commend you for the great work you’ve done since your elevation to CEO and President in 2008 and also to share three concerns that, if resolved, would translate your progress to date into more significant returns for shareholders.

Since taking over ARIS in 2008, you’ve done an impressive job leading and growing the company. Revenues, EBITDA and cash flow are up 12%, 15% and 18% CAGR, respectively and I believe sustainably. These results are driven by both organic growth and acquisitions that have expanded the company to new end-markets served and services offered.

Concurrently, the market value of the company is up ~25% CAGR as well, an impressive rate of growth that reflects the changes you’ve implemented.

And with the recent acquisition of DCi, you’ve added a tool in the automotive space that’s essential to your customers. DCi is a bit like the ARI business from 2008; a small no growth cash flow engine. And combined with TCS and TASCO you have the ingredients to create a sticky, recurring business that addresses the automotive end market with a product that's desired by customers and cannot be easily emulated elsewhere.

This letter however is not just about patting you on the back it is also about advising you and your board cc’d to really internalize the detrimental impact of the past seven years of share dilution and urge you to think more constructively and objectively about its impact going forward.



As the above table demonstrates, when we look at your financial performance on a per share basis – and as a part owner of your business, it is the only way for me to think about it - the results are largely unimpressive. Revenues and EBITDA flat. EPS down 11% CAGR.

I’d be remiss if I failed to point out one bright spot; the growth in book value per share. Though it comes off an extremely low base, it is the only remaining financial emblem of your value creation to date when viewed through the lens of share count dilution.

I can imagine back in 2008, a plan discussed and agreed to by the board to grow the company through acquisitions using a combination of debt and equity. This plan I imagine balanced benefits of increased liquidity, trading volume and a larger product offering against the disadvantages of shareholder dilution.

I would like to know if such a plan existed and if so, I should hope it is now complete. ARI’s portfolio of end markets and services has dramatically expanded and with 17M shares now outstanding, there’s plenty of stock to trade, particularly with an average daily volume of only 30,000 shares.

So I am writing to urge you and the board cc’d here to stop the share count dilution and suggest that on the next conference call you make it plain and clear that you pledge to stop the share count dilution and live only on your free cash flow and where necessary, low cost debt that is available to you.

Furthermore, as I’ve previously mentioned [in earlier conversations], I urge you to provide more disclosure around your subscriber numbers, whose growth is a major factor in organic growth (price being the other). This disclosure would provide valuable information to investors and a simple target around which to configure incentives.

And finally, there would be no better way for you, your executives and the board to indicate your trust and faith in the company that I share than buying its shares in the open market with your own money and not through stock grants and options.

In summary,

·        Stop the dilution
·        Disclose your subscribers
·        Buy the stock with your own money in the open market

Shares are not free money; they come with incredibly high costs in future value and their persistent use destroys everything you’re trying to build. It is simply impossible for any of us to earn a reasonable return on our investments with continued dilution of our capital.

With the business today more firmly ensconced in larger end markets and with additional services, I’m confident that sound and strategic management that generates organic growth will yield the cash flow necessary, over time and with patience, to grow the business while satisfying the required returns for its owners and executives.

Sincerely / 

Long Cast Advisers, LLC