Source: LOHAS Weekly Newsletter
Published: Sunday, November 01, 1998

The now-legendary August market correction was not a huge surprise to everyone. Federal Reserve Chairman Alan Greenspan had long suspected that the stock market was overvalued and puckishly attributed it to “irrational exuberance.” Had he focused on the valuations of vitamin, mineral and supplements (VMS) company stocks, he might have been tempted to use words such as “insane exuberance.” And in the end, it took fear of an Asian crisis to make such exuberance more rational.

For VMS companies, the potentially insane valuations have been wrung out from their stock prices. For example, Rexall Sundown (RXSD) was recently trading at $18.50, down from its 52-week high of $39; Twinlab (TWLB) was at $21, down from its high of $47.79; and NBTY was at $7, down from $24.38.

There are a number of reasons for the valuations of VMS companies to be down. Among those specific to the industry, the biggest, perhaps, is growth rate. It seems unlikely that the industry as a whole can sustain the year-to-year growth rate that it has been enjoying. It can be argued that the industry has already seen the peak in demand for its products. Additionally, the base from which the annual growth is calculated is now quite large, making formidable the task of maintaining the same percentage rate of increase from year to year.

Second, mainstream health care providers and their allies are calling for more FDA control of the supplements industry. To wit, Barron’s published an editorial in its March 24, 1997, issue, expressing skepticism about alternative medicine—vitamins and supplements included. In the Sept. 17, 1998, issue of The New England Journal of Medicine, a highly respected medical journal, authors Dr. Nancy Slifman et. al., based upon two cases, traced patients’ exposure to cardiac glycosides to herbal products labeled as containing plantain, which were contaminated with Digitalis lanata.

Recently conducted tests commissioned by the Los Angeles Times on the St. John’s wort products of various VMS companies, which found discrepancies, also received wide publicity (see related story, pg. 3).

Third, just as the industry reported flat sales in June, General Nutrition Cos. (GNCI) announced price cuts as large as 40%. As larger players such as American Home Products (Solgar), Bayer (One-A-Day) and Warner Lambert (Quanterra), which generally focus on mass-market channels, become more prominent, price competition is going to further intensify, and only those companies with a critical mass will remain viable. The bottom line, however, is the same—as the growth rate slows and retail-level prices are cut, margins all around, including those in manufacturing, are going to suffer, a situation translating into downward pressure on company valuations.

Now let us look at the effect on valuations resulting from recent changes in the capital markets. The high multiples at which the public VMS companies traded gave them the capability to acquire other, mostly private, companies at valuations of double-digit cash-flow multiples. The companies still found such acquisitions to be accretive to earnings. A major part in this scheme was a method of accounting for business combinations called pooling of interest. While this method requires fulfillment of certain stringent conditions before it can be applied, it offers a major advantage that regardless of how much you pay for an acquired company, no goodwill appears on the books. The transactions so accounted for must, in effect, involve exchange of shares.

In today’s market, public companies’ ability to value an acquisition in the stratosphere has all but disappeared because of (a) a decline in their own stock price and (b) an emerging preference of sellers to be paid in cash rather than in shares of the acquirer. A cash sale precludes any possibility of accounting for the acquisition by pooling of interest and creates goodwill on the balance sheet, which must be amortized quarterly against the EPS of the acquirer.

An example that comes to mind is the acquisition earlier this year of Nutrition Headquarters (NHQ) by NBTY (NBTY). NBTY exchanged about 9 million of its shares, then valued at $180 million, for shares of NHQ. At today’s value, the same shares would be worth approximately $63 million, a decline of almost $120 million in value. If the transaction, which was accounted for by pooling by NBTY, had been recorded employing purchase accounting, it would probably have been dilutive to NBTY’s earnings.

These factors have caused the gap between valuations of a VMS company by ‘strategic’ buyers and ‘financial’ buyers to close. In fact, private equity may now even have an advantage inasmuch as financial buyers generally use cash as the acquisition currency, which in today’s market may be at a premium for a public company.

Despite the two recent cuts in the federal funds rate by the Federal Reserve, the Asian crisis has caused a bit of a credit crunch. As a result, lenders have decreased the amount of cash they are willing to lend as a percentage of total acquisition price. Additional equity, which demands no less of a return on the additional amounts, must fill this gap. What then resolves the equation is lower valuations.

We would expect that as the companies in this industry get larger and the analysts more sophisticated, the analysts would begin to value VMS companies based not on quarter-to-quarter increases in the EPS, but on increases in economic value added.

All in all, we remain bullish on the VMS industry and feel that the industry will continue to offer attractive opportunities for savvy investors, in both public and private arenas.

Chance Bahadur is president of the Chicago-based The Bahadur Group Inc., a management group of former Fortune 300 senior executives interested in investment of private equity capital to create a large company in the dietary supplements industry. For more information, call 312.629.0030.