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GNC Holdings Inc  (NYSE:GNC)
Q4 2018 Earnings Conference Call
March 07, 2019, 8:30 a.m. ET

Contents:

Prepared Remarks:

Operator

Good day, and welcome to the GNC Fourth Quarter and Full Year 2018 Earnings Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Matt Milanovich, Head of Investor Relations. Please go ahead, sir.

Matt Milanovich -- VP-Investor Relations & Treasury

Good morning, and thank you for joining us on GNC's fourth quarter 2018 conference call. I would like to remind everyone that during this conference call, GNC management will make certain forward-looking statements about its outlook that involve risks and uncertainties. Forward-looking statements are generally preceded by words such as believe, plan, intend, expect, anticipate or similar expressions. Forward-looking statements are protected by the Safe Harbor contained in the Private Securities Litigation Reform Act of 1995. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstance that are difficult to predict and many of which are outside of the Company's control. Factors that could cause actual results to differ from expectations include, but are not limited to, those factors set forth in GNC's filings with the SEC. GNC is making these statements as of March 5th, 2019 and assumes no obligation to publicly update or revise any forward-looking statements.

In addition to the GAAP results, GNC will provide certain non-GAAP financial measures. GNC's earnings press release for the fourth quarter of 2018 can be found under the News Release link on the Investor Relations page of the Company's website at www.gnc.com. The tables attached to that earnings press release include reconciliations of the non-GAAP financial measures to the most directly comparable GAAP financial measures.

With that, I'll turn it over to our Chairman and CEO, Ken Martindale.

Kenneth A. Martindale -- Chairman and Chief Executive Officer

Thank you, Matt. Good morning, everyone. Thank you for accommodating the change in release timing. We felt it was important to communicate the details around our recently formed joint venture with International Vitamin Corporation concurrently with the results of the fourth quarter.

As you can see, we achieved some major milestones in strengthening our balance sheet and repositioning the Company during the past several weeks. We were pleased to receive the final $150 million tranche of Harbin Pharmaceutical Group's $300 million investment, culminating a yearlong effort to formalize our partnership.

With the transaction complete, we are launching two joint ventures with Harbin that will give us access to an extensive distribution network and deep manufacturing expertise in China. The Hong Kong-based China JV, which operates the existing cross-border e-commerce business, and is the largest current growth driver in China, was formed simultaneously with the closing of the Harbin investment.

Over the next few quarters, we'll complete the permitting and regulatory filing process to kick off the China JV and finalize the contribution of the existing China assets to the newly formed joint venture. The China JV will include the retail stores in China and the pharmacy distribution channel. When the China joint venture is finalized, Harbin will contribute $20 million of working capital to the newly formed entity.

This morning, we also announced in a separate press release a strategic joint venture agreement with International Vitamin Corporation, a global leader in vitamin and nutritional supplement manufacturing. Under the terms of the agreement, GNC will receive $101 million from IVC and contribute the net assets of the Nutra manufacturing facility and Anderson facility in exchange for an initial 43% ownership in the joint venture.

Over the next four years, GNC will receive an additional $75 million from IVC as IVC's ownership of the joint venture increases to 100%. The joint venture will be responsible for the manufacturing of the products currently produced by Nutra. This strategic partnership with IVC gives us access to their industry-leading experience and expertise, greatly increases our manufacturing capacity and lets us leverage the collective buying power of the two organizations. Over time, it will provide us a level of efficiency that we could not have achieved on our own while allowing our team to continue focusing on delivering high-quality, innovative products to our customers.

In addition, IVC has capacity to scale up, giving us room for future growth and supporting our global expansion plans without the need for significant future capital investment. As part of the transaction, IVC will take over manufacturing and integrate into GNC supply chain management while product development and innovation will stay in the hands of GNC's expert internal team. Quality assurance will be a shared responsibility moving forward.

IVC has exceptional in-house end-to-end manufacturing capabilities supported by an integrated ERP system and the expertise to keep GNC at the forefront of our industry. It has a stable supply of low-cost raw materials and more than 1 million square feet of manufacturing, packaging, warehousing and distribution facilities in the US as well as a growing global presence with existing facilities in Europe and China.

The IVC partnership is consistent with our emphasis on streamlining business processes and gives our team the freedom to focus on what we do best, understanding today's rapidly changing consumers and bringing innovative products to life. In the coming months, we will work closely with the IVC team to integrate our operations and continue delivering great service to all of our customers, including our franchisees.

As part of our continued efforts to strengthen and ultimately restructure our balance sheet, we use the proceeds from the China and Nutra transactions to retire the remainder of our B-1 Term Loan and further paid down the B-2 extended Term Loan.

Now, let me take a few minutes to talk about recent results. Our adjusted EBITDA performance was below our expectations, driven by both margin and SG&A impacts, which Tricia will cover in a few minutes shortly. We were however, satisfied with the underlying sales trend during the quarter. Our domestic retail comp trend improved to negative 1.4% and we continue to be encouraged by the results of our modified sales incentive program that focuses our team on increasing foundational product sales. Our e-commerce business grew even as we cycled against two years of significant growth and the anniversary of GNC products being available on Amazon Prime. The maturity of our Amazon Prime relationship will provide a headwind in 2019.

Now, let's turn to progress we're making on a go-forward strategy. In the US domestic retail business, we're making progress against our plan to increase the productivity of our retail portfolio by renegotiating lease terms, closing unproductive stores and transferring sales to stronger locations nearby. As we mentioned last quarter, we have identified 700 to 900 unproductive stores to be closed over the next three years. Our plan generally align store closures with lease terminations, resulting in minimal write-offs and cash expense as the current portfolio's average remaining lease term is less than three years.

Our store closure process is rigorous and focused on minimizing closing costs, retaining our best people and maximizing sales volume in surrounding stores. In 2018, the team closed 257 stores and exceeded their sales transfer goal of 30%. Keep in mind, our stores have high fixed cost, driven by large portion of the stores operating with one person at a time. So, transfer-related increases in volume have a positive impact on the affected stores' EBITDA.

Our international business continues to grow and posted strong results with a 12.1% year-over-year revenue increase. The results were driven by strength in China, Mexico and South Korea, and we continue to believe that the business is well-positioned as we head into 2019. More specifically in China, the world's second largest health and wellness market, our business was up 30% in the fourth quarter, driven by growth in cross-border e-commerce.

As we begin to leverage Harbin's distribution network in regulatory, operational and manufacturing experience through the JV, we expect to generate additional momentum in this business. Being relevant to consumers and delivering a constantly excellent experience, one that's personalized and aligned with your changing expectations is our path to growth and differentiation. Our loyalty program, myGNC Rewards, finished the quarter with 17 million members, including 1 million PRO Access members. The program provides opportunities to build stronger relationships with our existing customers and drive more meaningful personalized experiences.

Over the next three years, we will strategically invest in the systems and software needed to deliver a true omni-channel experience being very-targeted with our capital. In 2019, we will focus that investment on strengthening our e-commerce and mobile platforms and on improving our order management capabilities. We plan to replace our current order management system over the next year, giving us the capability to efficiently add services like buy online, pickup in store; and buy online, ship from store. Additionally, this new system will result in improved delivery service speed and cost-effective international e-commerce capabilities.

We continue to make positive strides with our own brands and in the fourth quarter, GNC branded products made up 54% of our sales. This is up from 48% at this time last year and 52% in Q3, partly driven by the introduction of our innovative Earth Genius brand in TamaFlex, which addresses unmet consumer needs.

Our wholesale division continues to represent an opportunity to increase revenues by putting our well-recognized brands in front of consumers who don't currently shop with us. New customers can engage with our products in these channels creating an opportunity to attract them back into our retail stores and GNC.com, where they can see our full product line and experience everything that GNC has to offer. We recently extended our 20-year relationship with Rite Aid for another three years and gained more flexibility to partner with retailers in different channels.

Looking ahead, I see tremendous opportunity and potential for GNC. We've made substantial progress in strengthening our balance sheet and putting ourselves in a position to succeed. We have a strong highly recognized brand and a strategy to leverage that brand across multiple channels, touching both existing and new customers. And while we still have much work to do, we feel good about the foundation that we've laid to regain momentum in the business throughout the coming year.

With that, I'll turn it over to Tricia for a closer look at the quarter.

Tricia Tolivar -- Executive Vice President and Chief Financial Officer

Thanks, Ken, and good morning, everyone. Over the past 16 months, we've reduced our debt by approximately $500 million and reduced go-forward annual interest costs by more than $30 million. As Ken mentioned, we used the proceeds from the joint venture investments to pay off our B-1 Term Loan and pay down the B-2 extended Term Loan. Additionally, we now have three strategic partners to grow the business, a Hong Kong JV, a China JV, and a manufacturing JV.

As we move into 2019, the formation of the Hong Kong and China joint ventures will result in an operating income reduction of approximately $6 million compared to 2018. The joint venture's operating performance, net of taxes, will be recorded as an adjustment to the income statement between operating income and net income. As a 35% owner of the newly formed JVs in 2019, GNC will recognize its share of the Hong Kong and China JV's profitability net of tax as a line item between GNC's operating income and net income on the income statement.

Additionally, GNC will recognize royalties in GNC's International segment operating profit. In 2019, as compared to 2018, we expect no material impact to net income as a result of the formation of the joint venture. Going forward, the joint venture will heavily invest in marketing to drive an expected $200 million in revenue for the joint venture over the next three years.

Let me give you some more specifics on the manufacturing joint venture starting with the details of the investment. In March of 2019, IVC's $101 million investment gives them 50% of our Nutra business. Over the next four years, IVC will gradually increase their stake in Nutra with four approximately $19 million annual investments, until they own the business outright in February 2023. Our joint venture with IVC gives us a level of efficiency that we cannot achieve on our own and allows us to focus on what we do best. In addition, it provides incremental capital to reduce our outstanding debt.

Now, moving on to the impacts to our financials related to this joint venture. As a reminder, the Nutra business is included in our Manufacturing and Wholesale segment. Going forward, the impact to this segment without Nutra is a decrease of approximately $25 million to $30 million in EBITDA. As a 43% owner of the JV, in 2019, GNC will recognize its share of the JV's profitability net of tax as a line item between GNC's operating income and net income on the income statement.

Turning to our Q4 financial results, our adjusted EBITDA of $35 million was below our expectations, largely driven by a $2.5 million reserve as a result of balance sheet risk associated with a third-party vendor, a $2.5 million correction related to previously recorded revenue for specialty manufacturing, and $3 million in store compensation driven by incremental store associate commissions. In 2019, much of the store compensation impact will be offset by changes to other components to the commission structure. Overall, salaries and benefits for domestic retail in 2019 is expected to be slightly higher as a percent of sales, driven by minimum wage rate increases.

Fourth quarter consolidated revenue was $547.9 million compared with $562.8 million in the fourth quarter of 2017. The decrease is primarily attributable to store closures at the end of the lease term, which is a component of our store portfolio optimization strategy. Fourth quarter same-store sales, including GNC.com, were down 0.6%. E-commerce sales were 9.3% of US and Canada revenue in the current quarter compared with 8.4% in the prior year quarter, driven by growth in revenue from both GNC.com and our Amazon Marketplace.

Our e-commerce comp sales increased 5.9% in the fourth quarter. Keep in mind that we're comparing against two years of significant growth from this channel and we've now lapped the first year of our partnership with Amazon. And as Ken mentioned, this presents a headwind for us going into 2019.

Revenue from our domestic franchise locations decreased $5 million due to a 1.3% decrease in same-store sales and a decrease in the number of franchise stores. Revenue from our international business was up 12.1%, driven by increased China cross-border e-commerce sales and strong performance from franchisees in Mexico and South Korea. As previously mentioned, the Harbin joint venture partnership unlocks our expansion into China, and we're working in key markets such as India, the Philippines and Europe.

Manufacturing and wholesale revenue, excluding intersegment sales, decreased $3.4 million, driven by the $2.5 million adjustment from the previously recorded revenue for specialty manufacturing that I mentioned earlier. This adjustment also drove the $3.3 million reduction in adjusted operating income compared to the prior year.

Fourth quarter gross profit was 31.5% compared with 32.6% in the prior year. As we discussed on our last call, the fourth quarter is our seasonally slowest quarter resulting in deleverage from occupancy and distribution, which are largely fixed costs. Margins were also negatively impacted by the $2.5 million reserve related to the risk associated with the third-party vendor and the specialty manufacturing adjustment previously noted. Excluding the one-time impact, margin rate was up 44 basis points compared to the third quarter of 2018.

At 27.1% of sales, fourth quarter adjusted SG&A was 200 basis points above last year due to one-time legal settlement benefits in the fourth quarter of 2017 and incremental associate commissions from the program introduced in August 2018 to build basket as previously mentioned.

We are encouraged by the early results of our Companywide cost optimization plan, which we will continue to expect to deliver $15 million to $20 million in savings in 2019 with an additional $25 million to $30 million in 2020. In 2018, we generated $95.9 million in net cash from operating activities, invested $19 million in capital expenditures and generated $95.7 million in free cash flow.

Fourth quarter free cash flow benefited from a $12.4 million tax refund related to 2017. For the 12-month period ended in December 31st, 2018, our total net debt to adjusted EBITDA, which includes adjustments from our credit agreement, is 4.9 times. We reiterate our long-term lease adjusted net leverage target at 3 times with rent capitalized at 5 times. As previously mentioned, we received a full $300 million investment from Harbin and $101 million from IVC that will show an additional decrease in our leverage ratio in the first quarter. In 2019, we will continue to use the majority of our free cash flow to pay down debt. In 2019, we also expect to incur a lease liability between $525 million and $575 million on our balance sheet related to the new lease accounting rules.

From a P&L standpoint, we expect in 2019 for occupancy to decrease $20 million due to this lease accounting change as well as our continued ongoing efforts to lower rent expense. The finalization of the Harbin transaction and recent IVC joint venture, along with the reduction of approximately $500 million in debt in the last 16 months, has positioned us to succeed. We're currently working with both new joint venture partners on initiatives that will enhance our long-term strategy, and we look forward to sharing more details with you later this year.

With that, let's open the call for your questions.

Questions and Answers:

Operator

Thank you. (Operator Instructions) We can now take a question from Huang Yang from Citi. Please go ahead. Please unmute your line, sir.

Huang Yang -- Citigroup -- Analyst

(technical difficulty)

Tricia Tolivar -- Executive Vice President and Chief Financial Officer

I'm sorry. I didn't catch that question.

Huang Yang -- Citigroup -- Analyst

Hi. Can you hear me?

Tricia Tolivar -- Executive Vice President and Chief Financial Officer

Yes.

Huang Yang -- Citigroup -- Analyst

I'm sorry. So, just you had nice sequential improvement in the same-store sales in the domestic stores. What's driving that? Any particular products or categories that are a standout?

Tricia Tolivar -- Executive Vice President and Chief Financial Officer

Yes. So, we introduced two new product lines, TamaFlex and Earth Genius, in the latter part of Q3, and those certainly were significant drivers to both the same-store sales as well as the improvement in our GNC brand mix to 54% in the fourth quarter.

Huang Yang -- Citigroup -- Analyst

And so then, if I look at the EBIT in your domestic store segment, what were the actual gross margins, and I'm sorry if I missed it on the on the product side?

Tricia Tolivar -- Executive Vice President and Chief Financial Officer

Yeah. So, the gross margins were impacted by a couple of one-time adjustments that we talked about earlier. So, first, there was a $2.5 million adjustment related to one of our third-party vendors and some balance sheet risks there. So that was incurred in the quarter. Additionally, in the quarter from a margin perspective on the US and Canada segment, there was an adjustment where there was an impact related to our PRO Access program. So we made some changes to that program during the year that improved the experience for the customers but also added some incremental costs. And what we've been able to do as we go into 2019 is maintain that service level but minimize the cost impacts and bring us back to a more normalized level back to 2017. So, the combination of those items as well as some impacts in SG&A related to the incentives for our commission structure, those were the biggest drivers of the reduction in EBITDA in that segment.

Huang Yang -- Citigroup -- Analyst

But, is -- is it really one-time or should we think about these margins as sort of a reset for that segment?

Tricia Tolivar -- Executive Vice President and Chief Financial Officer

Certainly, the call-outs that I made on the margin side, the $2.5 million and the other PRO Box impacts were one-time in nature.

Huang Yang -- Citigroup -- Analyst

Okay. And then, just lastly on the new JV with ICV, is it -- IVC, I'm sorry, when is the transition -- are there any risks to transitioning the business or is it really -- or the manufacturing is going be done in the same facilities so it doesn't really make a difference?

Kenneth A. Martindale -- Chairman and Chief Executive Officer

The joint venture is in the same facility, and it's one of the reasons that we've structured it the way that we have. The teams have been working together to put a transition plan together. We are anxious to start leveraging the opportunities we have to drive cost out together, but first and foremost, we want to make sure that we're really focused on the transition going smoothly. So, the teams are working together. They're down there meeting today, and we're off and running. But we're going to take it slow and steady and make sure that we manage the transition as carefully as we can.

Huang Yang -- Citigroup -- Analyst

Thank you.

Operator

(Operator Instructions) We can now take our next question from Hale Holden from Barclays. Please go ahead.

Hale Holden -- Barclays -- Analyst

Hi. Thank you for taking my call. I was just wondering if you could just give us the current outstanding balance on the B-2 post for IVC pay-down.

Tricia Tolivar -- Executive Vice President and Chief Financial Officer

The outstanding balance on the B-2 as of yesterday is $458 million. There's $275 million outstanding and as a FILO and the remaining outstanding on the converts that existed at the end of this calendar year. There's nothing outstanding -- there's nothing outstanding on the ABL.

Hale Holden -- Barclays -- Analyst

Perfect. I appreciate it. Thank you.

Operator

(Operator Instructions) There are no further questions on the line at this time. I would now like to turn the call back to the host for any additional or closing remarks.

Matt Milanovich -- VP-Investor Relations & Treasury

Great. Well, we thank you all for joining us. And again, I appreciate you accommodating the change in the call time. We look forward to talking to you guys again in another quarter. Have a great day.

Operator

Thank you. That concludes today's conference. Thank you for your participation, ladies and gentlemen. You may now disconnect.

Duration: 30 minutes

Call participants:

Matt Milanovich -- VP-Investor Relations & Treasury

Kenneth A. Martindale -- Chairman and Chief Executive Officer

Tricia Tolivar -- Executive Vice President and Chief Financial Officer

Huang Yang -- Citigroup -- Analyst

Hale Holden -- Barclays -- Analyst

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