"In a word: Good. In two words: Not good" Reviewing $FTLF and $FHCO

A friend of mine recently told me this terrific joke ...  

Two old mates run into each other.
"How are you?" says one
"In a word: good. In two words: not good." 

... incongruency, surprise and some revelation of truth are key sources of humor according to Freud - they certainly make the joke work.

They are all key elements of investing as well.

Responding to the inevitable surprises of investing with an even keel, without emotion, by revisiting assumptions and figuring out the important lessons to takeaway are among the essential elements of patient investing.

This post is about recent surprises regarding stocks I've written about: $FTLF in its recently filed 10K and $FHCO with its recently announced merger with Aspen Park Pharmaceutical.

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There are many moving parts to $FTLF and the summary thesis, which I laid out in an earlier post, is as follows:

FTLF makes branded sports nutritional supplements
They sell primarily (+90% of revenues) brand exclusive products to GNC franchise stores
They are "in" ~900 of GNC's ~1,000 franchise stores.
Previously, they sold direct to these locations
At year end 2014 GNC notified them that they were no longer able to sell direct and would be required to sell through the GNC wholesale channel
Franchisees stocked up on inventory; sales expanded, then collapsed and 2015 was a year of slowly returning to prior levels.
The company just anniversaried the year's disruption from this channel change (a good thing; comps are easy), but the change brings with it the following negative issues ...
GNC is now an intermediary and has more control on price. Sales are discounted ~15%. Some of that is made up via lower shipping costs and the disappearance of transaction fees offset by higher DSO's. Furthermore, a primary benefit of direct sales to franchises was the opportunity to offer a copycat product at a lower price to the consumer and a higher margin to the franchisee. Franchisees we've spoken with said this remains true but at lower levels (ie its still a higher margin product, but not as much).
... the three big tailwinds for the company are 1) y/y comps are easy so we should dd organic growth all year, 2) they recently acquired a poorly run competitor but with a product that consumers and stores like so overall topline should be quite dramatic ~50% y/y and 3) best of all, over the next three years, GNC is transitioning 1,000 corporate stores to franchise stores meaning - at face value - shelf space for their core customer and core business is about to double. I say "at face value" b/c this is a brutal competitive business with incredible competition for shelf space. It is fought franchise by franchise and store by store by sales rep educating the local salesforce on the value of the product.

$FTLF filed its' 10K 4/15 and it came with good news and bad news. I'll start with the negative surprises ...

Inventory expanded to $4.8M meaning turns were below the 4-6 targeted range.
The sales discount through the GNC Corporate distribution model widened to 15% from 10%
The option to acquire 600,000 shares issued it IFIT's former CEO Stephen Adele expired unexercised.
After deducting one time merger costs, EBITDA margins for the year were 5%

... all of this raises doubts about my $30M sales / 10% EBITDA margin expectations that had been the foundational thesis to the stock.

It wasn't all bad news - organic sales growth was ~20% - and I had expected 4Q to be messy with management "kitchen sinking" all kinds of costs post merger, but the inventory figure had me concerned enough to wake up the next morning in a sweat.

I subsequently talked with the CFO and I got a pretty narrative along the lines of ... "the past was bad b/c of XYZ but the future is wonderful" ... which didn't answer anything about the inventory, nor the wider than expected sales discount, nor the margins, nor the possibility of management conflict since their largest shareholder is the former CEO of the company they just acquired and whose business was managed E.N.T.I.R.E.L.Y differently (and incredibly poorly, to boot).

If I had $1 for every time a mgmt team provided a narrative answer instead of a substantive one to simple business questions, I wouldn't have to work anymore and certainly I wouldn't wake up in a sweat thinking: "there's got to be better ways to make money than investing in nano-caps."

But patient investing is about navigating those surprises.

Are the inventory issues temporary or terminal? 

High inventory can mean stocking ahead of sales, the timing of shipments, acquiring raw materials before a cost increase or any number of things that aren't just "good" or "bad". Too soon to say.

Are these new risks or symptoms of risks I am already aware of? 

GNC is the price setter, no doubt, and now that FTLF must sell through the corp distribution system, they exist solely for GNC's interest in providing alternative product to its franchisees. This was known ahead of time.

Also, this is a brutally competitive business.

The future opportunity remains driven by GNC's re-franchising strategy - converting 200 stores this year and 1,000 over the next three years from GNC corporate to GNC franchise stores - as well as getting iSatori products on more shelves in independent stores.

If there's one underlying thing FTLF does it's, it's good at getting product on shelves profitably and living on its own cash flow. I've seen no evidence (yet) to dispute that assumption.

What can I do to learn more so that I don't have to rely on a mgmt narrative with an obvious agenda? 

The only thing I can think of is to revisit the channel checks. When I was a kid we used to visit every home furnishings store b/t home and our destination b/c of the family curtain business. We'll be visiting a few GNC franchise stores enroute to Colonial Williamsburg on our next vacation. (I doubt they have NDS products in Ye Olde Farmacy).

The good news on FTLF is they report 1Q16 in less than a month, it's typically their strongest quarter and it will provide a better sense of performance than the kitchen sinked messy year end.

Part of patient investing is waiting, learning, researching, checking (and re-checking) assumptions and not throwing in the towel b/c of one bad quarter that you had a sense ahead of time would be bad. If they can penetrate the new franchise stores the way they penetrated the existing ones, core revenues would double over three years + the added benefit of the iSatori product = potential for significant upside.

***

In my +20 years as an investor, the bulk as a professional analyst, I have never had a "WTF!" moment like I had reading the $FHCO merger press release. Pairing a cash flow generating value company with a speculative pre-clinical phase pharmaceutical company is a deal that makes so little sense - it is so incongruous - that as Freud predicted, you almost have to laugh. And no doubt there are plenty of jokes to make.

I have written about $FHCO a few times on this blog. I bought the stock the first time in the ~$4 range after the dividend was cancelled. I sold it for a loss in the ~$2.50 range when I fully understood that the product was an irrelevant joke and then management was not much better.

I bought it back in the ~$1.35 range after the prior CEO was fired and OB Parrish resumed his leadership. The thinking then was that he'd lost so much money over the last two years, and the stock was so cheap, he would do the right thing to restore the value by simply using the copious cash flow to buy back shares and get the product on consumer shelves.

I sold a bunch of the shares north of $2 when Bares showed they'd unloaded their stock but I own enough to remain an active observer.

And I observe that FHCO, which manufactures and sells the female condom, and generates +95% of sales from developing world NGO's, will merge with Aspen Park Pharmaceuticals, a company run by two urologists / serial entrepreneurs with lousy records of value creation.

APP has new formulations of existing drugs in preclinical and clinical phases for prostate cancer and hypogonadism (ie low testosterone) and a consumer product called Preboost "a disposable, pre-moistened wipe that uses a safe, highly effective topical anesthetic ... Slightly desensitizing the penis slows down a man’s sexual response without interfering with pleasure or orgasm."

It is my belief - a product of my imagination based on many conversations with OB Parrish before and after the deal - that the entirety of the deal is OB Parrish's hope - no doubt sold to him - that the guy who got Preboost on the shelves can also get the FC2 on the shelves, and the oncology drugs are just icing on the cake, if they pan out (and in the development phase oncology world, who really knows?).

I came to this conclusion in this order ...

1. I wondered if OB Parrish lost his mind.
2. I wondered how many people thought OB had lost his mind when he invested in a small company that had acquired rights for the female condom
3. I reflected on his patience in refining and bringing his product to market
4. And on his unusual relationship with the product, which, for reasons that are unclear to me, he sort of withholds from the consumer market.
5. And finally it dawned on me that this guy is playing the "long game" and - while we don't know what's in his head - to him this must represent something "heroic"
6. However, it's not something someone does with a strong hand so maybe it's also a bit of an admission of what I've learned, that his product is a bit of joke, a novelty like preboost and he sees the writing on the wall, that at the end of the day the FDA will down-classify the female condom and he'll be left with nothing.

But who knows what will happen? The deal needs a super majority to pass and it seems possible he won't have the votes.

Unlike with $FTLF I have a very limited pathway to learning more. The key here is understanding the value of the development drugs at APP ...

delayed release Tamulosin
APP-111
MSS-722 for secondary hypogonadism
APP-944 for male hot flashes

... and I tend to avoid med-tech / pharma for the speculativeness of their products and b/c I don't have enough sources to make informed decisions. But I do have a few folks I can talk with and as I learn anything material from the urologists and other folks I intend to speak with, I will post it here.

With $FHCO, I don't yet have an opinion one way or the other and therefore see no reason to make a decision either way. But it is a strange situation. I have low expectations but plenty of patience.

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