MusclePharm: An Overlooked Value Investment In The

MusclePharm: An Overlooked Value Investment In The Booming Supplement Industry
December 12, 2012

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)

Despite a general consensus that business activity in the global economy has been stagnant recently, there are particular industries that are bucking that trend with rapid expansion. Healthcare, in particular, has shown very strong resistance to the recent economic downturn. I've covered numerous areas of the pharmaceutical industry that have seen (or will see) enormous expansion over the next few years, but have yet to really explore the growth we've seen in the nutraceutical and nutritional supplement sector in coming years.

As a direct response to a parabolic rise in obesity rates in the United States and most other Western nations, health products have seen skyrocketing sales figures as more and more emphasis is being placed on fitness and well-being. Companies that sell fitness supplements have benefitted tremendously.

GNC Holdings (GNC) was one of them, and has seen a doubling of its stock price since its IPO in April of 2011. Since inception, GNC stock has outperformed both the S&P 500 and the Dow Jones Industrial Average by 94%. Another notable example is Vitamin Shoppe Inc. (VSI) which saw roughly 230% appreciation since its IPO in November of 2009. Since inception, VSI outperformed both the S&P 500 and the Dow Jones Industrial Average by 196%.

Recent IPOs of highly recognized companies (in other industries) have fallen flat on their face due to Wall Street's inability to gauge a company's worth. Perhaps the most high-profile example was the Facebook (FB) IPO, which was priced on a bunch of intangibles and funny numbers derived from its large subscriber base. Recall that Facebook became a NASDAQ stock on May 17, 2012 at an initial price of $38/share, but has fallen about 30% since due to a lack of actual financial data that justifies the company's market capitalization (which now hovers just under $60 billion.)

The neutraceutical/supplement industry, on the other hand, has shown very steady top-line growth that could directly boost the value of the companies in it. This is basically why the market has been so bullish on GNC and VSI post-IPO, and will continue to do so as long as the growth remains intact.

A big, upcoming name in the industry is MusclePharm Corporation (MSLPD.OB). MusclePharm has not seen as much attention due to the young age of the company (it was started in 2008) and the company's shady financial history. There is also the fact that company shares are not available on either of the two major US stock exchanges (the New York Stock Exchange or the NASDAQ), which makes MusclePharm equity quite illiquid and hard to discover right now. Nonetheless, the company has a story that could be interesting to investors who are looking for the next big play in healthcare products.

MusclePharm's history dates back to 2006, when the original founder Cory Gregory sold his services as a fitness trainer in Nevada. His company Tone in Twenty offered muscle-regenerative isometric techniques, which are increasingly popular amongst professional athletes. MusclePharm CEO Brad Pyatt was then coming out of his four-year tenure in the National Football League (which started with the Indianapolis Colts in 2003). His years in the world of professional sports taught Brad a lot about supplements and the existence of inferior products on the market, which birthed the idea that a new supplement company could be viable competition for the big brands. It was only a matter of time after Brad Pyatt met entrepreneur Cory Gregory that the business concept would be made into reality.

As mentioned earlier on, MusclePharm began its operations in 2008 out of Brad Pyatt's garage. Despite a modest $300,000 pool of startup capital, MusclePharm's CEO Brad Pyatt and Cory Gregory, managed sales revenue of $80,000 by the end of the year. Their success early in the year led an IPO, which raised additional capital used to fuel the massive top-line growth that MusclePharm would see over the next few years through a beefed-up marketing budget.

By 2011, MusclePharm reported $17 million in sales revenue. This equates to a 2,125% increase in revenue over three years, or an annually compounded growth rate of 597% top-line growth.

As one might expect, this hyperbolic growth rate came at a big cost. The supplement business is virtually a carbon copy of the athletic apparel business, where branding is the single most important factor for the success of any company. Realizing the obvious importance for MusclePharm to develop as a brand, the company spent generously on its "beefed-up" marketing budget throughout the first few years of operation.

Aggregated throughout the first few years of operation, you can see that MusclePharm spent about $10 million to launch and to build its brand presence. This was close to the same amount of money that MusclePharm raised from its IPO in the first few years, and debt had to be issued.

The major problem was that MusclePharm's debt financing was structured very poorly by its former CFO. This resulted in the issuance of an enormous pool of convertible notes that induced egregious dilution of the stock, and made the ticker extraordinarily risky - even for investors who buy shares through uncentralized markets. The company began to undergo a convertible debt retirement program in January 2012, which repurchased $5.5 million worth of toxic derivatives with $3 million in cash derived from sales revenue and with 55 million shares of MSLPD by the end of Q1 2012.

This has made MusclePharm much more accessible to both institutional investors attempting to mitigate the risk in their portfolios, as well as the individual investors who are less knowledgeable about debt structuring and the potentially dilutive effects of financial derivatives.

Viewing the most recently released version of the company's balance sheet (from their SEC 10-Q filing released on November 13, 2012) shows that MusclePharm's financial position as of September 30, 2012 was improved relative to September 30, 2011. It may seem dangerous that company only holds $634,000 in cash (even less than 2011, when the company held $660 million), but note that there is an enormous build-up of over $4 million in accounts receivable which should be translated into eventual cash flow as we head into 2013. There was also an apparent investment in company property and equipment, which paves the way for MusclePharm to create a self-sufficient supply chain for their product in future years.

The most important (and beneficial) change to the company's balance sheet was the reduction of derivative liabilities from over $7 million to a negligible sum of $25,000 as of the end of Q3 2012. As mentioned earlier, these derivatives were causing major uncertainty amongst investors due to their complicated nature and association with high risk.

One thing that has plagued MusclePharm's business model has been its reliance on third party manufacturers, which has crushed the company's profit margins, hence preventing the company from posting earnings growth in league with revenue growth. This problem also helps explain why the company is consistently low on cash, and has not seen all that much interest from Wall Street's equity analysts.

MusclePharm's EBITDA (earnings before interest, taxes, depreciation, and amortization) for Q3 was $4.07 million. Out of total net sales of $18.56 million for Q3 2012, we calculated that COGS (cost of goods sold) is about 78%. This makes profit margins only 22%, which is an extremely low figure for any business. When you subtract SG&A (or sales, general & administrative) expense from EBITDA you get negative earnings. For MusclePharm in Q3, $7.88 million worth of SG&A expense brought the company negative operational income of $3.8 million. Note that the final losses were higher due to roughly $2 million in additional expenses for the quarter related to the removal of derivative liabilities. Since that was a one-time expense, it can be ignored from a long-term perspective.

If you compare MusclePharm to a somewhat similar name like GNC, you'll note that there is a significant gap in the two companies' profitability relative to revenue. Specifically using their Q3 2012 results, you can calculate that GNC had COGS of 62% and gross margins of 38%. MusclePharm, eager to improve on this front, is looking to expand its margins by about 10% through in-house manufacturing and distribution of its supplements. The exact timeframe has yet to be revealed by company management, although this does develop the notion that MusclePharm is not trapped in an unprofitable distribution model forever.

What's also important to realize about MusclePharm is that it's a very young company that has already proven its competitive edge in the supplement industry through its huge sales growth. This translated into strong historic top-line growth for the company, with continued expectations of this trend. Also vital to its success is its unique management team.

CEO Brad Pyatt is clearly different than GNC's corporate-flavored CEO Joseph Fortunato, since Mr. Pyatt has firsthand experience with the products he now sells and has a profile that should make MusclePharm more accessible to professional athletes as a sponsor. It's not just potential in football either. For instance, note that MusclePharm is the official sponsor of the increasingly popular UFC (Ultimate Fighting Championship.) Also worth noting is MusclePharm's new and highly regarded CFO Gary Davis, who led the fitness website BodyBuilding.com into #1 status between 2006 and 2010. It seems quite certain that Mr. Davis will become integral to MusclePharm's competitive strategy going forward.

Investors who are either long or considering MusclePharm as we head into a new fiscal year should be looking for a continuation of the company's success as measured by top-line growth, and also development on the company's plans to manufacture and distribute its own product. The company's COGS is not so great, but can certainly be improved in coming quarters.

This is essential to the company's valuation down the line, of course, since earnings are supposed to be the most fundamental driver of stock prices anyway. There are few exceptions out there when it comes to retailers, but some names like Amazon (NASDAQ: AMZN) manage to sell the top-line growth story alone quite well.

If MusclePharm can continue its success on the top-line while fixing its cost structure, shareholders could see some huge gains when investors realize that there is a lot of momentum (and money) being created in the supplement industry.

http://seekingalpha.com/article/1059481-muscl...t-industry