GNC (GNC) surprised many income investors when management recently announced that the company’s dividend will be suspended.
After all, GNC has been in business for more than 80 years, maintains a payout ratio below 40%, generates solid free cash flow, and even increased its dividend every year since it began paying one in 2012 – including an 11% boost just last year.
These are some of the qualities we look for when evaluating companies for our Conservative Retirees dividend portfolio.
None of these strengths mattered, however.
GNC’s double-digit yield was wiped out immediately, adding insult to injury after the stock’s 70%+ decline over the past year.
Dividend safety and capital preservation are two keys for conservative investors living off dividend income, and GNC clearly failed to deliver.
But investors could have known in advance to avoid GNC, well before its precipitous stock price decline and dividend suspension.
Let’s take a look at why GNC ultimately decided to cut its dividend and how investors can avoid similar traps going forward to protect their retirement portfolios.
Analyzing GNC’s Business
GNC is a specialty retailer of nutritional supplements (i.e. vitamins, herbs, meal replacements, sports nutrition) and has a worldwide network of more than 9,000 stores (most are company-owned in the U.S., but over one thousand U.S. locations are franchised).
Most of GNC’s stores are located in shopping malls and strip shopping centers, and the company has benefited from the rise in nutritional supplements.
At first glance, GNC seems like an interesting play on the health and wellness theme, which shows no signs of slowing down.
In addition to growing industry demand, GNC enjoys some of the strongest brand awareness in the space, positioning itself to remain a trusted leader.
Unfortunately, mismanagement and a major shift in the competitive landscape caused GNC’s quick fall from the top.
In fact, the company’s interim CEO confessed that GNC had “a badly broken business model” in October 2016.
Competition from online nutritional sellers became increasingly fierce, and fewer consumers had a need to actually shop at specialty retailers’ stores.
GNC’s discount-driven pricing system also proved to be too confusing, especially as consumers increasingly price shopped online while in stores.
GNC replaced its CEO during the summer of 2016 as the company continued delivering disappointing results and was desperate for a faster turnaround.
The company re-launched its brand at the end of 2016, rolling out the “One New GNC” strategy that focuses on simplified pricing and a free loyalty program.
Despite its struggles, GNC continued generating positive free cash flow over the past year, and quarterly revenue never declined by more than 9% year-over-year.
So why did GNC cut its dividend? Let’s take a closer look.
GNC’s Dividend Safety Score
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a company’s dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at a company’s most important metrics such as payout ratios, debt levels, free cash flow generation, industry cyclicality, profitability trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
The chart below plots each company’s Dividend Safety Score on the x-axis and the size of its dividend cut on the y-axis. You can see that almost all companies cutting their dividends scored below 40 for Dividend Safety at the time of their announcements, and companies with lower Dividend Safety Scores generally experienced larger dividend cuts.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been (including analysis of every dividend cut in the chart above), and how to use them for your portfolio.
GNC’s Dividend Safety Score at the time of its dividend cut announcement was 27, indicating that the company’s dividend was unsafe and at risk of being cut.
At a glance, GNC’s dividend cut comes as a bit of a surprise. The company’s free cash flow payout ratio came in below 40% in 2016, which is a healthy level for almost any business and about in line with GNC’s payout ratio in recent years.
While it’s true that free cash flow per share declined in 2016 to $2.14, that amount easily exceeded GNC’s annual dividend amount of 80 cents per share.
What ultimately did in the dividend was GNC’s persistent sales decay (which shows no sign of turning around anytime soon), the company’s high fixed costs, and GNC’s excessive financial leverage.
As you can see, GNC’s sales decline started at the end of 2015 and accelerated through 2016.
With thousands of company-owned store locations, GNC has a number of fixed costs it incurs to keep its stores open, regardless of revenue trends.
In other words, when sales drop, there is little GNC can do to offset the lost revenue – most of the decline comes straight out of bottom line profits.
And shrinking profits, with no end in sight, are a major concern for highly leveraged businesses.
GNC has a history of being passed around from one private equity firm to the next, which is why the company carries such a massive debt load.
As you can see, the company’s debt to capital ratio routinely sat above 50% and increased substantially in recent years.
My preference is to avoid companies with a debt to capital ratio above 50%, and I will only invest near that threshold if the business has extremely stable earnings (e.g. a regulated utility). GNC does not pass that test.
Looking closer at the numbers, GNC ended 2016 with just $34 million in cash on hand, which is miniscule compared to its $1.5 billion debt burden and annual commitments for $60 million in interest expenses and $55 million in dividends.
GNC is also on the hook for more than $100 million per year in operating lease obligations, which it must pay for store locations that it rents rather than owns.
Simply put, GNC’s highly leveraged balance sheet and financial commitments jeopardize the company’s future if cash flow continues shrinking.
Slashing the dividend saves GNC $55 million per year, which isn’t much compared to its total debt burden but provides some relief (especially given its low cash balance and the reinvestment it is making to change its strategy).
With roughly $1.3 billion in debt coming due in 2018 and 2019, GNC is wise to position itself as best as it can to refinance its loans, especially with its turnaround efforts likely several quarters away from delivering any meaningful traction (if they ever do).
In fact, S&P lowered GNC’s credit rating from BB+ to BB with a negative outlook in August 2016 as management’s turnaround efforts failed to generate traction.
Here’s what management said about the dividend cut:
“As you know, the board regularly reviews uses of cash. Their decision to suspend the dividend is consistent with the fundamental changes in our business and will give us greater flexibility as we implement the One New GNC. Consistent with prior periods, we expect to use cash flow in excess of what we invest in our business to pay down our debt…”
A combination of pricing and merchandising blunders, secular pressure on mall-based stores, a continued shift in consumer shopping preferences, and excessive financial leverage ultimately brought down GNC’s dividend – even despite its “healthy” payout ratio and free cash flow generation.
Closing Thoughts on GNC’s Dividend Cut
If it sounds too good to be true, it usually is. Dividend yields above 5% begin to get murky, and most yields near 10%, such as GNC’s, often don’t end well.
The pursuit of current income through high dividend stocks has many benefits, but it should never come at the cost of capital preservation.
Payout ratios and free cash flow generation can help assess how safe a dividend is, but they are only part of the picture.
Financial leverage is an extremely important dividend safety factor, and investors should also be confident in the long-term outlook of the companies they invest in.
Given the number of business challenges that bubbled up at GNC over the last year, a number of questions should have been raised about the company’s future well before the dividend cut.
Retail has always been a challenging industry to invest in because of fickle consumer preferences, and the ongoing e-commerce wave has only further complicated life for brick-and-mortar retailers such as GNC.
Turning around a struggling retailer is extremely difficult (just take a look at J.C. Penney), and GNC’s financial strain won’t make things any easier going forward.
As a conservative investor, I will continue to avoid GNC. Sure, there is potential for the stock to do extremely well from here if management’s turnaround is successful, but the stock could also go to zero if cash flow shrinks at a brisker pace over the coming years. The odds seem stacked against GNC’s recovery for now.