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GNC Holdings (NYSE:GNC)
Q1 2019 Earnings Call
April 25, 2019 8:30 a.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Good day, and welcome to the GNC Holdings, Inc., first-quarter 2019 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 -- Head of Investor Relations
Good morning, and thank you for joining us for GNC's first-quarter 2019 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 projected 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 circumstances 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 April 25, 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.
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GNC's earnings press release for the first quarter of 2019 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 reconciliation to 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.
Ken Martindale -- Chief Executive Officer
Thanks, Matt, and good morning, everybody. We appreciate you joining us today. We are pleased with our adjusted EBITDA margin improvement that we delivered in the first quarter of 2019. Our international business continued to show strength in the quarter, as did our domestic franchise stores, which delivered their first positive comp in several years.
Sales in our domestic retail business were largely in line with our expectations, but e-commerce underperformed. As we discussed in last quarter's call, we continue to face headwinds in our Amazon business, and our team is actively engaged with their partners at Amazon, working to strengthen the current sales trends. We are also conducting an aggressive search for a chief digital officer. Let me give you a quick update on the two strategic partnerships that closed during the first quarter.
We are working closely with Harbin Pharmaceutical Group to position our China joint venture for success. Our teams have been hard at work aligning on priorities, solidifying our management team, and executing the first steps of the joint venture business plan. We continue to believe that the Harbin partnership will accelerate our presence and maximize our opportunities for growth in the $25 billion Chinese supplement market. In addition, we have transitioned our day-to-day manufacturing and supply chain operations to the newly formed manufacturing joint venture with International Vitamin Corporation.
The GNC and IVC teams are working extremely well together, and we remain confident that our partnership will deliver meaningful efficiencies and allow our team to do what we do best, bringing innovative products to the marketplace. With these partnerships up and running, we are intently focused on improving results in our domestic stores. As part of our store portfolio optimization initiative, we closed 87 corporate stores during the first quarter, and our average sales transfer rate from closed stores to nearby locations continues to exceed our 30% target. We continue to see strength in sales of our own brands, and in the first quarter, GNC-branded products made up 52% of our domestic sales.
This is up from 50% at this time last year. While developing our own products is at the heart of our innovation strategy, we also look for emerging exciting brands with whom we can build strategic relationships. We have long-standing partnerships with various brands, for example, the Nugenix line of supplements for men and Ghost performance products. In March, we launched Alani Nu, an exciting new line of women's nutritional supplements that has gained national popularity through the endorsement of an exceptionally visible social media influencer.
In each of these cases, our scale and large customer base generate visibility and growth for these brands, while their unique and exclusive products further differentiate us and attract new customers and new kinds of customers to GNC. Earlier this week, we announced the introduction of a line of topical CBD products to stores in 23 states and the District of Columbia. We are well-positioned to capitalize on the growing consumer demand for CBD-related products and are taking great care to find strong partners and identify products that are right for the GNC brand and for our customers. With a million full-access customers and 17 million myGNC Rewards members in total, our loyalty program data provides us unique opportunities to truly personalize our customers' experiences.
While personalization is not something you can implement overnight, we are beginning to gain traction. Over the past two quarters, our direct marketing has become much more personalized. We are now able to show customers a mix of their favorite items, recommend complementary products, and personalize offers specifically for them in several marketing channels. We're seeing positive results from this targeted approach and are gearing up to introduce it in other digital touch points soon.
We're also working to improve the in-store experience. This work includes giving greater visibility to new products and testing new shelf and aisle layouts, with the goal of making it easier for our customers to shop our stores. In addition, our lab store gives us a place to test new customer experiences and merchandising concepts that may have application to other GNC stores based on what we learn. We continue to add functionality with tablets associates are using on the sales floor, and we're leveraging this technology to improve the customer experience.
Associates can now use the tablets to gain insights and assist customers on many elements of our loyalty program, as well as sign up customers for our Auto-Deliver and Save subscription program. Auto-Deliver and Save subscriptions continue to grow and provide a convenient solution to our busiest customers. Shifting gears, let's quickly talk about our international segment. We continue to see growth with several of our key franchise partners, and plan on releasing our first shipments to our recently signed partners in Australia and Japan later this year.
On the innovation front, two weeks ago, we converted an existing location in Shanghai, China, to our first global showroom store. This store carries an expansive virtual assortment of products available to view in store with the help of an associate or a nutritionist. This showroom store gives customers greater access to a full range of GNC products, which they can order in-store via mobile or Web and have the products shipped directly to their homes. We will continue to monitor the performance of this location and apply the learnings from the store in other markets.
In closing, I'd like to extend a special thanks to all the GNC associates who continue to deliver great customer experiences every day. We feel good about the progress we are now making. And while we know we have a great deal of hard work ahead of us, we're encouraged by the traction we're beginning to see on a number of fronts as we continue working to position the company for long-term growth. With that, I'll turn it over to Tricia for a look at the quarter and a deeper dive into some of our key strategic initiatives.
Tricia Tolivar -- Chief Financial Officer and Executive Vice President
Thanks, Ken, and good morning, everyone. Our quarterly adjusted EBITDA of $66 million was up 11% over the first quarter of last year, driven by lower occupancy, more normalized marketing, reduced other SG&A, and lower salaries and benefits, partially offset by decreased product margin as a result of lower revenues. Occupancy expense was lower by nearly $15 million, driven by the new lease accounting standards related to impaired stores, 295 closed stores since the first quarter of 2018, and negotiated rent reductions. Lower marketing levels were the result of investments to support the launch of Slimvance in 2018, that did not reoccur in 2019, bringing our first-quarter 2019 marketing spend to more normalized levels.
First-quarter consolidated revenue was $564.8 million, compared with $607.5 million in the prior year. The decrease is primarily attributable to the transfer of the Nutra manufacturing and China e-commerce businesses to the newly formed joint ventures and the closure of company-owned stores from our store optimization initiative. First-quarter same-store sales, including e-commerce, were down 1.6%. E-commerce sales were 7.4% of U.S.
and Canada revenue in the current quarter, compared with 7.1% in the prior-year quarter. Our e-commerce sales increased 1% in the first quarter. And as Ken mentioned earlier, our e-commerce business has been softer in recent quarters due to headwinds with the amazon.com marketplace. We continue to expect our Amazon business to be challenged in the short term.
Revenue from domestic franchise locations was flat year over year, while comp sales were up 0.6% in the first quarter. Revenue from our international business, excluding China, was up 13%, driven by strong performance from franchisees in Singapore and South Korea. Close to one-half of this increase is a result of softer sales in Q1 of 2018. That could slightly negatively impact second-quarter growth.
Separately, as mentioned previously, the transfer of the China e-commerce business to the joint venture resulted in an expect decrease in revenue. Note that the China-related sales were $35 million for Q2 through Q4 of 2018. Manufacturing and wholesale revenues, excluding inter-segment sales, decreased $20.4 million, primarily due to the transaction with International Vitamin Corporation for the newly formed manufacturing joint venture on March 1. This transaction will impact revenue as follows.
In the U.S. and Canada, international, and Rite Aid, PetSmart and Sam's Club portion of the wholesale business, there will be no change to revenue. The revenues generated by the manufacturing business related to other contract manufacturing, and formerly included as part of GNC's wholesale revenue, will now be recognized by the newly formed joint venture, and no revenues will be reported by GNC. 2018 sales previously included in the manufacturing and whole segment, excluding inter-segment sales, were approximately $90 million for Q2 through Q4 in 2018, and will not be recognized by GNC on a go-forward basis.
First-quarter gross profit was 36% of sales, compared with 34.1% in the prior year. The improvement was primarily driven by occupancy savings as a result of the accounting treatment relating to impaired stores, store closings associated with the store optimization program, and rent reductions. The occupancy savings is expected to be less significant over the course of 2019 as we anniversary an increasing number of store closures. At 26.1% of sales, first-quarter adjusted SG&A was down 20 basis points from last year, primarily driven by more normalized marketing expense and partially offset by higher salaries and benefits as a percent of revenue.
We expect SG&A to be down by more than $30 million in 2019, driven by cost savings and store optimization initiatives. As a percentage of revenue, we expect SG&A to range from 26% to 28%, increasing throughout the year largely as a result of seasonality. As Ken mentioned, I'd like to give you some additional color on a couple of our initiatives. Let's start with IVC.
I gave a little information regarding revenue a few minutes ago, but I'd like to spend a few more minutes to cover the overall impact of the transaction. As you know, this joint venture agreement gives $101 million in upfront gross proceeds in exchange for 57% ownership in our Nutra manufacturing business. IVC will acquire the remaining 43% interest for an additional $75 million over the next four years. The IVC transaction is a productive strategic partnership for GNC.
We now have access to IVC's manufacturing capabilities, efficiencies and low-cost sourcing without compromising product development and innovation, which will stay firmly with GNC. The $25 million to $30 million annual reduction in EBITDA, noted on our prior call, will be reflected in the manufacturing and wholesale segment. Product margins of the U.S. and Canada and international segments will not be impacted by this transaction.
We will begin to see the impact of this EBITDA reduction in the second quarter as we start selling the inventory purchased from the manufacturing joint venture after March 1. The full EBITDA impact will be realized starting in the third quarter. And as such, consolidated margins will be negatively impacted by 80 to 100 basis points in Q3 and Q4. Keep in mind, however, that GNC will record 43% of any profits from the joint venture as an adjustment to income between operating income and net income.
We have locked in pricing for two years, and after that, revised pricing will be based on a formula that is driven off of the joint venture cost savings. In addition, we would have had to spend capex to continue operating the facility at historical levels of efficiency, which we estimate will eliminate approximately $30 million in investment over the next three years. Shifting back to the overall business, we expect consolidated gross profit to range from 32% to 35% for the remainder of the year, recognizing that the manufacturing joint venture impact I just discussed and seasonality will have a larger negative impact in the back half of the year. Finally, I'd like to give you a more detailed look at our debt and the progress we have made to improve our capital structure.
We reduced debt by over $500 million since the fourth quarter of 2017, and our total net debt to adjusted EBITDA, which includes adjustments from our credit agreement, is approximately 3.5 times. We expect the leverage ratio to increase about a half a turn over the course of the year as we realize the $25 million to $30 million loss in EBITDA associated with the formation of the manufacturing joint venture. We ended the quarter with $137 million in cash and an undrawn revolver. Free cash flow increased $116.8 million, to $154.3 million.
The increase was due to $100 million in proceeds from the Nutra manufacturing transaction, favorable working capital changes primarily due to an increase in accounts payable as a result of the company's cash management efforts, and the increase in accounts payable related to the establishment of the manufacturing joint venture. With that, let's open the call for questions.
Questions and Answers:
Operator
[Operator instructions]. We can now take our first question from Bob Summers from Buckingham Research. Please go ahead.
Bob Summers -- Buckingham Research -- Analyst
Good morning, guys. Just on the comp, could you maybe talk about the cadence of the comp through the quarter? I mean, I think that retail in general had some challenges in February that were weather-related. I'm just curious if you were wrapped up into that and kind of where we exited the quarter.
Tricia Tolivar -- Chief Financial Officer and Executive Vice President
We certainly did see some softness in February, impacted by weather and some other factors, and March certainly performed better than February.
Bob Summers -- Buckingham Research -- Analyst
And then just what's interesting to me is the EBIT margin in the U.S. business, just the overall rate, and then the fact that dollars grew year over year. Are these levels that I should expect for the remainder of the year?
Tricia Tolivar -- Chief Financial Officer and Executive Vice President
So our EBITDA dollars in the first quarter are going to be the strongest than they will be throughout the year, but we're certainly focused on continuing to see EBITDA dollar improvement on a year-over-year basis as we fully implement our cost savings and store optimization initiatives.
Bob Summers -- Buckingham Research -- Analyst
And then just on the CBD products, any expectation on what kind of traffic that might drive? I mean, I think that it's a differentiated product that customers have been asking for for a while, and I'm just kind of curious as to internally how you're thinking about it.
Ken Martindale -- Chief Executive Officer
Bob, it's really hard to forecast right now, because this is such a quickly moving, evolving category. So we don't really have any forecasts particularly, but we absolutely have been getting a lot of requests from customers, and we've taken a fairly cautious approach to this as we continue to monitor the regulatory environment. And as that environment continues to evolve, we will evolve with it. We've spent a lot of time looking at the products that are available on the market, and we feel pretty good about the partners that we're joining on this effort.
So we expect this to just be a slow build as this category continues to evolve, but we're excited to have the products in store now.
Bob Summers -- Buckingham Research -- Analyst
And I guess related to that, maybe you might have more visibility into I guess two things. One, when sort of the topicals get bought or adoption in some of the states that are currently excluded, and then just what does the timeline look for ingestible? I mean, I think that you have a lot of people out there that are rogue, that aren't necessarily being prosecuted, as it were, by the FDA right now, but how does that evolve?
Ken Martindale -- Chief Executive Officer
That is a fantastic question, and you need a crystal ball to really figure that out. It is evolving, I mean, almost daily, believe it or not. Things are moving around so quickly. The edible market, we don't know where it's going to go.
We're staying very, very close to it. But as I said, we've tried to take a very cautious approach here, and a lot of our teams wanted to jump into this, but we wanted to make sure that we really evaluated the ongoing changes in the regulatory environment, so we're just going to continue to watch it. I wish I had better answers for you, but I really don't know right now. It changes day to day.
Bob Summers -- Buckingham Research -- Analyst
And then last one, just remind me again what the issues are with the Amazon marketplace and why we're confronting challenges.
Tricia Tolivar -- Chief Financial Officer and Executive Vice President
So we're seeing a bit of a decline in our buy box percentage, so a number of our products are showing up in the gray market, so we're now aggressively going after those sellers to remove them from the market and do what we can to improve that buy box percentage on a go-forward basis.
Ken Martindale -- Chief Executive Officer
There's one other thing too, Bob, that's kind of popped up over the last year. We've been a Prime eligible seller now for over a year, and it's a different business model because everything is very quickly delivered, and the costs are a little bit more expensive, so we have fine-tuned our selection a little bit on Amazon Prime as well, because some of the products just were not profitable for us to sell. So it does impact us a little bit on the revenue side, but it helps us on the EBITDA side. So we're continuing to work with the Amazon team and look forward to trying to strengthen the sales trends on Amazon.
Operator
[Operator Instructions] We can now take our next question from Hale Holden from Barclays. Please go ahead.
Hale Holden -- Barclays -- Analyst
Good morning. Thank you for taking my call. I had two questions. The first one is, just as a follow up on the CBD offering, is that going to be GNC branded and/or available through the PetSmart and Rite Aid agreements too, or just in your stores as a third-party sale?
Ken Martindale -- Chief Executive Officer
At this point, it is not a GNC-branded product. We'll continue to look at opportunities there, and as they develop, it's certainly possible that we will introduce some of those products. But today, we've partnered with two manufacturers that have been in this space for a while and understand it very well, and we're relying on their capabilities and expertise. So for right now, we've got two brands of product that we're introducing to the stores, and we certainly had the opportunity to share these products with other partners, but at this point in time, it's just available in GNC stores in selected states.
Hale Holden -- Barclays -- Analyst
And then my second question is you mentioned at the start of the call a women's nutritional supplement, the visible influencer. I was wondering if you could give us a little bit more color on that and if that was a repeatable model or how that kind of came to be and some of the metrics around it?
Ken Martindale -- Chief Executive Officer
Our team is constantly looking at driving innovation, and we do it, from the merchandising side, both with our own brands and with partner brands, and we've talked a lot about some of the progress we've made on the GNC-branded product over the last few quarters. But this is an example of a small -- they were only sold online, and it's an emerging brand that our team was connected with and evaluated and really liked. The team that's behind this product liked their marketing plan and the quality of the products they brought to market, and so we've been spending several months bringing this product into our DCs, building a marketing plan to launch it, and we're very happy with it so far. So, yes, it is a repeatable model for us.
As we said, there are tremendous advantages to us and to these third-party brands, because we certainly give them the scale to get their product into the market, and a lot of these folks have very differentiated and interesting products that help add to our differentiation and bring new customers in. So we're always on the lookout for new, emerging brands, and we're excited about this one.
Tricia Tolivar -- Chief Financial Officer and Executive Vice President
In particular, as well, we're working with our existing vendor partners and future partners on identifying opportunities for them to assist in driving new traffic into the stores, and that's a critical component of future launches in GNC as well.
Hale Holden -- Barclays -- Analyst
Thank you very much. I appreciate it.
Operator
That concludes today's Q&A. I would now like to turn the call back to Ken Martindale for any additional or closing remarks.
Ken Martindale -- Chief Executive Officer
Well, great. Thank you again. We really appreciate everybody joining us today, and we look forward to talking to you in another three months. Have a great day.
Operator
[Operator signoff]
Duration: 27 minutes
Call Participants:
Matt Milanovich -- Head of Investor Relations
Ken Martindale -- Chief Executive Officer
Tricia Tolivar -- Chief Financial Officer and Executive Vice President
Bob Summers -- Buckingham Research -- Analyst
Hale Holden -- Barclays -- Analyst
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