TMCnet News
GNC HOLDINGS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with Item 1, "Financial Statements" in Part I of this Quarterly Report on Form 10-Q. Forward-Looking Statements This Quarterly Report on Form 10-Q and any documents incorporated by reference herein or therein include forward-looking statements within the meaning of federal securities laws. Forward-looking statements include statements that may relate to our plans, objectives, goals, strategies, future events, future revenues or performance, capital expenditures, financing needs and other information that is not historical information. Forward-looking statements can often be identified by the use of terminology such as "subject to," "believe," "anticipate," "plan," "potential," "predict," "expect," "intend," "estimate," "project," "may," "will," "should," "would," "continue," "seek," "could," "can," "think," the negatives thereof, variations thereon and similar expressions, or by discussions of strategy. All forward-looking statements, including, without limitation, our examination of historical operating trends, are based upon our current expectations and various assumptions. We believe there is a reasonable basis for our expectations and beliefs, but they are inherently uncertain. We may not realize our expectations, and our beliefs may not prove correct. Actual results could differ materially from those described or implied by such forward-looking statements. The following uncertainties and factors, among others (including, but not limited to, those we describe under the caption "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2013), could affect future performance and cause actual results to differ materially from those matters expressed in or implied by forward-looking statements: • significant and growing competition in our industry; • unfavorable publicity or consumer perception of our industry or products, as well as general changes in consumer behaviors and trends; • increases in the cost of borrowings and limitations on availability of additional debt or equity capital; • our debt levels and restrictions in our debt agreements; • incurrence of material product liability and product recall costs; • loss or retirement of key members of management; • costs of compliance and our failure to comply with new and existing governmental regulations governing our products, including, but not limited to, proposed dietary supplement legislation and regulations; • changes in our tax obligations; • costs of litigation and the failure to successfully defend lawsuits and other claims against us; • failure of our franchisees to conduct their operations profitably and limitations on our ability to terminate or replace under-performing franchisees; • economic, political, and other risks associated with our international operations, including fluctuations in foreign currency exchange rates relative to the U.S. dollar; • failure to keep pace with the demands of our customers for new products and services; • limitations of or disruptions in our manufacturing system or losses of manufacturing certifications; • limitations of or disruptions in our distribution network; • lack of long-term experience with human consumption of ingredients in some of our products; 18-------------------------------------------------------------------------------- Table of Contents • increases in the frequency and severity of insurance claims, particularly claims for which we are self-insured; • failure to adequately protect or enforce our intellectual property rights against competitors; • changes in raw material costs and pricing of our products; • failure to successfully execute our growth strategy, including any delays in our planned future growth, any inability to expand our franchise operations or attract new franchisees, any inability to expand our company-owned retail operations, any inability to grow our international footprint, or any inability to expand our e-commerce business; • any failure by our current marketing initiatives to timely produce the results that we anticipate; • changes in applicable laws relating to our franchise operations; • damage or interruption to our information systems; • risks and costs associated with data loss, credit card fraud and identity theft; • impact of current economic conditions on our business; • unusually adverse weather conditions; • natural disasters, pandemic outbreaks, boycotts, and geo-political events; and • failure to maintain effective internal controls. Consequently, forward-looking statements should be regarded solely as our current plans, estimates and beliefs. You should not place undue reliance on forward-looking statements. We cannot guarantee future results, events, levels of activity, performance or achievements. We do not undertake and specifically decline any obligation to update, republish or revise forward-looking statements to reflect future events or circumstances or to reflect the occurrences of unanticipated events. Business Overview We are a global specialty retailer of health and wellness products. We derive our revenues principally from product sales through our company-owned stores and online through GNC.com, LuckyVitamin Corp. ("Lucky Vitamin"), and Discount-Supplements.co.uk ("Discount Supplements"), domestic and international franchise activities and sales of products manufactured in our facilities to third parties. We sell products through a worldwide network of more than 8,800 locations operating under the GNC brand name. We acquired Discount Supplements, the leading multi-brand sports nutrition e-commerce retailer in the United Kingdom, in October 2013. In August 2014, our board of directors authorized a multi-year program to repurchase up to an aggregate of $500.0 million of our Class A common stock (the "common stock"). This replaces the repurchase program established in November 2013. We repurchased $230.3 million of common stock during the nine months ended September 30, 2014 and have utilized $40.0 million of the current repurchase program. On April 17, 2014, the Company acquired THSD d/b/a The Health Store ("The Health Store"), a nine store chain based in Dublin, Ireland. Executive Overview In 2014, we have continued to focus on our five principal corporate goals: growing company-owned domestic retail earnings, growing company-owned domestic retail square footage, growing our international footprint, expanding our e-commerce business and further leveraging the GNC brand. These goals are designed to drive both short-term and long-term financial results. Our results for the three months ended September 30, 2014 were affected by a difficult 19-------------------------------------------------------------------------------- Table of Contents retail environment. The following results are for the three months ended September 30, 2014 compared to the same period in 2013: • Our company-owned domestic same store sales decreased 5.8%, which includes a 4.2% decrease in sales by our GNC.com business. • We increased our company-owned domestic store count by 33 net new stores during the third quarter of 2014. • Our retail segment sales decreased 1.4%, and operating income decreased 3.5%. • Total franchising revenue and operating income decreased 3.1%. • Domestic franchising revenue increased 7.3%, and we added 79 net new domestic franchise stores since the third quarter of 2013. • International franchise revenue decreased 16.8%, and we added 25 net new international franchise stores during the third quarter of 2014. • Sales decreased in our wholesale/manufacturing segment by 11.4% due to reduced purchases from our large wholesale customers, and operating income decreased 19.4%. • Our total revenue decreased 2.7%, and our total operating income decreased 13.7%. For the nine months ended September 30, 2014, we generated net cash from operating activities of $238.0 million, repurchased $230.3 million in common stock, and paid $43.3 million in common stock dividends. Revenues and Operating Performance from our Segments We measure our operating performance primarily through revenues and operating income from our three segments, Retail, Franchise and Manufacturing/Wholesale, and through the management of unallocated costs from our warehousing, distribution and corporate segments, as follows: • Retail: Retail revenues are generated by sales to consumers at our company-owned stores and online through our websites, GNC.com, Lucky Vitamin, and Discount Supplements. Although we believe that our retail and franchise businesses are not seasonal in nature, historically we have experienced, and expect to continue to experience, a variation in our net sales and operating results from quarter to quarter. • Franchise: Franchise revenues are generated primarily by: (1) product sales to our franchisees; (2) royalties on franchise retail sales; and (3) franchise fees, which we charge for initial franchise awards, renewals and transfers of franchises. Although we do not anticipate the number of our domestic franchise stores to grow substantially, we expect to achieve domestic franchise store revenue growth generally in line with our domestic retail business, which we expect to generate from royalties on franchise retail sales and product sales to our existing franchisees. As a result of our efforts to expand our international presence and provisions in our international franchising agreements requiring franchisees to open additional stores, we have increased our international store base in recent periods and expect to continue to increase the number of our international franchise stores over the next five years. We believe this will result in additional franchise fees associated with new store openings and increased revenues from product sales to, and royalties from, new franchisee stores. Since our international franchisees pay royalties to us in U.S. dollars, any strengthening of the U.S. dollar relative to our franchisees' local currency may offset some of the growth in royalty revenue. • Manufacturing/Wholesale: Manufacturing/Wholesale revenues are generated by: sales of manufactured products to third parties, generally for third-party private label brands; the sale of our proprietary and third- 20-------------------------------------------------------------------------------- Table of Contents party products to and through Rite Aid and www.drugstore.com; and the sale of our proprietary products to PetSmart and Sam's Club. We also record license fee revenue from the opening of franchise store-within-a-store locations within Rite Aid stores. Our revenues generated by our manufacturing and wholesale operations are subject to our available manufacturing capacity. A significant portion of our business infrastructure is comprised of fixed operating costs. Our vertically integrated distribution network, manufacturing capacity, and ability to outsource production can support higher sales volume. We opened a fourth domestic distribution center in October 2014. This distribution center is located near Indianapolis, Indiana, and we believe that it will provide incremental distribution capacity sufficient for the foreseeable future. The following trends and uncertainties in our industry could affect our operating performance as follows: • broader consumer awareness of health and wellness issues and rising healthcare costs may increase the use of the products we offer and positively affect our operating performance; • interest in, and demand for, condition-specific products based on scientific research may positively affect our operating performance if we can timely develop and offer such condition-specific products; • the effects of favorable and unfavorable publicity on consumer demand with respect to the products we offer may have similarly favorable or unfavorable effects on our operating performance; • a lack of long-term experience with human consumption of ingredients in some of our products could create uncertainties with respect to the health risks, if any, related to the consumption of such ingredients and negatively affect our operating performance; • increased costs associated with complying with new and existing governmental regulation may negatively affect our operating performance; • consolidation within our industry and increasing participation in our market by mass market retailers and consumer product manufacturers could continue to intensify competition within our industry and could continue to negatively affect our market performance; and • a decline in disposable income available to consumers may lead to a reduction in consumer spending and negatively affect our operating performance. Results of Operations The following information presented for the three and nine months ended September 30, 2014 and 2013 was prepared by management, is unaudited, and was derived from our unaudited consolidated financial statements and accompanying notes. In the opinion of management, all adjustments necessary for a fair statement of our financial position and operating results for such periods and as of such dates have been included. As discussed in Note 9, "Segments," to our unaudited consolidated financial statements, we evaluate segment operating results based on several indicators. The primary key performance indicators are revenues and operating income or loss for each segment. Revenues and operating income or loss, as evaluated by management, exclude certain items that are managed at the consolidated level, such as warehousing and distribution costs, impairments and other corporate costs. The following discussion compares the revenues and the operating income or loss by segment, as well as those items excluded from the segment totals. Same store sales growth reflects the percentage change in same store sales in the period presented compared to the prior year period. Same store sales are calculated on a daily basis for each store and exclude the net sales of a store for any period if the store was not open during the same period of the prior year. We also include internet sales, as generated only through GNC.com and www.drugstore.com, in our domestic retail company-owned domestic same store sales calculation. When a store's square footage has been changed as a result of reconfiguration or relocation in the same mall or shopping center, the store continues to be treated as a same store. If, during the period presented, a store was closed, relocated to a different mall or shopping center, or converted to a franchise store or a company-owned store, sales from that store up to and including the closing day or the day immediately preceding the relocation or conversion are included as same store sales as long as the store was open during the same period of the prior 21-------------------------------------------------------------------------------- Table of Contents year. We exclude from the calculation sales during the period presented that occurred on or after the date of relocation to a different mall or shopping center or the date of a conversion. Results of Operations (Dollars in millions and percentages expressed as a percentage of total net revenue) Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 (unaudited) Revenues: Retail $ 480.7 73.2 % $ 487.3 72.2 % $ 1,495.2 74.5 % $ 1,483.3 73.6 % Franchise 114.1 17.4 % 117.8 17.5 % 327.8 16.4 % 336.0 16.7 % Manufacturing / Wholesale 61.5 9.4 % 69.4 10.3 % 183.0 9.1 % 196.0 9.7 % Total net revenues 656.3 100.0 % 674.5 100.0 % 2,006.0 100.0 % 2,015.3 100.0 % Operating expenses: Cost of sales, including warehousing, distribution and occupancy costs 408.6 62.2 % 421.3 62.5 % 1,246.0 62.1 % 1,250.2 62.0 % Compensation and related benefits 82.3 12.5 % 79.3 11.7 % 245.9 12.2 % 239.9 11.9 % Advertising and promotion 20.3 3.1 % 16.7 2.5 % 59.4 3.0 % 53.5 2.7 % Other selling, general and administrative expenses 30.1 4.6 % 29.7 4.4 % 97.5 4.9 % 91.8 4.6 % Amortization expense 2.7 0.4 % 2.1 0.3 % 8.1 0.4 % 6.3 0.3 % Management realignment 7.5 1.2 % - - 7.5 0.4 % - - International franchise receivable reserves 4.4 0.7 % 0.2 - 4.4 0.2 % 0.4 - Reversal of contingent purchase price (4.3 ) -0.7 % - - (4.3 ) -0.2 % - - Other (income) expense, net (4.0 ) -0.6 % (0.8 ) -0.1 % (9.5 ) -0.5 % (1.0 ) -0.1 % Total operating expenses 547.6 83.4 % 548.5 81.3 % 1,655.0 82.5 % 1,641.1 81.4 % Operating income: Retail 89.4 13.6 % 92.6 13.7 % 277.9 13.8 % 291.5 14.5 % Franchise 40.3 6.1 % 41.6 6.2 % 121.6 6.1 % 116.7 5.8 % Manufacturing / Wholesale 22.9 3.5 % 28.4 4.2 % 69.4 3.5 % 76.9 3.8 % Unallocated corporate and other costs: Warehousing and distribution costs (17.3 ) -2.6 % (17.5 ) -2.6 % (50.3 ) -2.5 % (50.7 ) -2.5 % Corporate costs (19.1 ) -2.9 % (19.1 ) -2.8 % (60.1 ) -3.0 % (60.2 ) -3.0 % Management realignment (7.5 ) -1.1 % - - (7.5 ) -0.4 % - - Subtotal unallocated corporate and other costs, net (43.9 ) -6.6 % (36.6 ) -5.4 % (117.9 ) -5.9 % (110.9 ) -5.5 % Total operating income 108.7 16.6 % 126.0 18.7 % 351.0 17.5 % 374.2 18.6 % Interest expense, net 11.8 11.3 35.0 33.4 Income before income taxes 96.9 114.7 316.0 340.8 Income tax expense 32.6 41.7 111.9 123.4 Net income $ 64.3 $ 73.0 $ 204.1 $ 217.4 Note: The numbers in the above table have been rounded to millions. All calculations related to the Results of Operations for the year-over-year comparisons were derived from unrounded data and could occasionally differ immaterially if you were to use the table above for these calculations. 22-------------------------------------------------------------------------------- Table of Contents Comparison of the Three Months Ended September 30, 2014 and 2013 Revenues Our consolidated net revenues decreased $18.2 million, or 2.7%, to $656.3 million for the three months ended September 30, 2014 compared to $674.5 million for the same period in 2013. The decrease was the result of decreased sales in all three business segments. Retail. Revenues in our Retail segment decreased $6.6 million, or 1.4%, to $480.7 million for the three months ended September 30, 2014 compared to $487.3 million for the same period in 2013, due primarily to negative domestic retail same store sales, which includes sales from GNC.com, of 5.8%. This decrease was partially offset by an increase in sales of $6.8 million in our e-commerce businesses (principally due to the acquisition of Discount Supplements which occurred in October 2013) and $13.3 million from the addition of 151 net new corporate stores and nine The Health Store locations in Ireland, acquired in April 2014. Our company-owned store base increased by 160 stores to 3,459 at September 30, 2014 compared to 3,299 at September 30, 2013, which includes the nine The Health Store locations and 14 new Canadian stores. Franchise. Revenues in our Franchise segment decreased $3.7 million, or 3.1%, to $114.1 million for the three months ended September 30, 2014 compared to $117.8 million for the same period in 2013. Domestic franchise revenue increased $4.9 million primarily due to higher wholesale sales of $5.2 million. Our domestic franchise same store sales decreased by 4.5% for the three months ended September 30, 2014 compared to the same period in 2013. There were 1,063 domestic franchise stores at September 30, 2014 compared to 984 stores at September 30, 2013. International revenue decreased by $8.6 million, or 16.8%, for the three months ended September 30, 2014, compared to the same period in 2013, due to lower wholesale product sales of $8.4 million, particularly due to regulatory and macro-economic factors in several key international franchise markets. Our international franchisees have reported a 2.9% same store sales decrease this quarter, on a local currency basis. Our international franchise store base increased by 146 stores to 2,101 at September 30, 2014 compared to 1,955 at September 30, 2013. Manufacturing/Wholesale. Revenues in our Manufacturing/Wholesale segment, which includes third-party sales from our manufacturing facilities in South Carolina, as well as wholesale sales to Rite Aid, PetSmart, and Sam's Club, decreased $7.9 million, or 11.4%, to $61.5 million for the three months ended September 30, 2014 compared to $69.4 million for the same period in 2013. Third-party contract manufacturing sales from our South Carolina manufacturing plant decreased by $7.3 million, or 19.2%, to $30.4 million for the three months ended September 30, 2014 compared to $37.7 million for the same period in 2013 due generally to softer market trends. Cost of Sales Cost of sales, which includes product costs, costs of warehousing and distribution and occupancy costs, decreased $12.7 million, or 3.0%, to $408.6 million for the three months ended September 30, 2014 compared to $421.3 million for the same period in 2013. Cost of sales, as a percentage of net revenue, was 62.2% and 62.5% for the three months ended September 30, 2014 and 2013, respectively. The lower cost of sales percentage for the three months ended September 30, 2014 was due principally to reduced promotional activities compared to the same period in 2013, partially offset by higher occupancy expense related to the operating of 160 new stores in our retail segment. Selling, General and Administrative ("SG&A") Expenses SG&A expenses, including compensation and related benefits, advertising and promotion expense, other SG&A expenses including amortization expense, increased $7.6 million, or 6.0%, to $135.4 million for the three months ended September 30, 2014 compared to $127.8 million for the same period in 2013. These expenses, as a percentage of net revenue, were 20.5% and 19.0% for the three months ended September 30, 2014 and 2013, respectively. Compensation and related benefits. Compensation and related benefits increased $3.0 million, or 3.8%, to $82.3 million for the three months ended September 30, 2014 compared to $79.3 million for the same period in 2013. The increase in store salaries and benefits was primarily to support our increased store base and expenses from our newly acquired retail businesses. Advertising and promotion. Advertising and promotion expenses increased $3.6 million, or 21.3%, to $20.3 million for the three months ended September 30, 2014 compared to $16.7 million for the same period in 2013. Advertising expense, as a percentage of net revenue, was 3.1% and 2.5% for the three months ended September 30, 2014 and 2013, respectively. The increase in our advertising expense as a percentage of net revenue is principally 23-------------------------------------------------------------------------------- Table of Contents due to increased media advertising related to the Beat Average™ marketing campaign and the acquisition of Discount Supplements, which occurred in the fourth quarter of 2013. Other SG&A. Other SG&A expenses, including amortization expense, increased $1.0 million, or 3.2%, to $32.8 million for the three months ended September 30, 2014 compared to $31.8 million for the same period in 2013. This increase principally relates to expenses from our newly acquired retail businesses. Other Management realignment. For the three months ended September 30, 2014, we incurred $7.5 million associated with the changes among our executive leadership team. This expense related principally to $5.7 million in executive severance, $0.5 million of accelerated non-cash stock-based compensation expense net of forfeitures, and $1.3 million for the recruiting and hiring of new executive leadership. International franchise receivable reserve. For the three months ended September 30, 2014, we recorded a $4.4 million reserve against receivables with our international franchisees, compared to $0.2 million for the same period in 2013. The collectability of receivables principally from one international franchisee has become uncertain due to its current financial condition. Reversal of contingent purchase price. During the three months ended September 30, 2014, it was determined that certain conditions required to be met by the seller in the purchase agreement of Discount Supplements were not achieved, and as such, we reversed a $4.3 million contingent purchase price liability ("Reversal of Contingent Purchase Price"). Other (income) expense, net. Other (income) expense, which includes the gain on sale of corporate owned stores to franchisees and foreign currency (gain) loss, increased $3.2 million to a gain of $4.0 million for the three months ended September 30, 2014 compared to a gain of $0.8 million for the same period in 2013. The increase in other (income) expense is a result of more conversions from corporate stores to franchise stores for the three months ended September 30, 2014 compared to the same period in 2013. Operating Income As a result of the foregoing, consolidated operating income decreased $17.3 million, or 13.7%, to $108.7 million for the three months ended September 30, 2014 compared to $126.0 million for the same period in 2013. Operating income, as a percentage of net revenue, was 16.6% and 18.7% for the three months ended September 30, 2014 and 2013, respectively. Retail. Operating income decreased $3.2 million, or 3.5%, to $89.4 million for the three months ended September 30, 2014 compared to $92.6 million for the same period in 2013. The decrease in operating income was primarily related to higher media advertising spend corresponding with our Beat Average™ campaign launch during the second quarter of 2014, and expense deleveraging associated with negative same store sales, partially offset by improved gross margin and the Reversal of Contingent Purchase Price. Franchise. Operating income decreased $1.3 million, or 3.1%, to $40.3 million for the three months ended September 30, 2014 compared to $41.6 million for the same period in 2013. The decrease was primarily due to the International Franchise Receivable Reserve adjustment of $4.4 million, partially offset by the gain of $4.1 million from the sale of corporate owned stores, which was an increase of $3.3 million over the gain of $0.8 million for the same period in 2013. Manufacturing/Wholesale. Operating income decreased $5.5 million, or 19.4%, to $22.9 million for the three months ended September 30, 2014 compared to $28.4 million for the same period in 2013. The decrease in operating income was generally due to lower shipments to wholesale customers for softer market trends as well as lower proprietary sales. Warehousing and distribution costs. Unallocated warehousing and distribution costs decreased $0.2 million, or 1.3%, to $17.3 million for the three months ended September 30, 2014 compared to $17.5 million for the same period in 2013. Corporate costs. Corporate overhead costs were $19.1 million for both the three months ended September 30, 2014 and 2013. 24-------------------------------------------------------------------------------- Table of Contents Management realignment. For the three months ended September 30, 2014, we incurred $7.5 million associated with the changes among our executive leadership team. This expense related principally to $5.7 million in executive severance, $0.5 million of accelerated non-cash stock option expense, and $1.3 million for the recruiting and hiring of new executive leadership. Interest Expense, net Interest expense increased $0.5 million, or 4.8%, to $11.8 million for the three months ended September 30, 2014 compared to $11.3 million for the same period in 2013. This increase was due to the effects of the additional borrowings of $252.5 million under the Senior Credit Facility, partially offset by interest rate savings resulting from the repricing of the Senior Credit Facility, both of which occurred during the fourth quarter of 2013. Income Tax Expense We recognized $32.6 million of income tax expense (or 33.7% of pre-tax income) during the three months ended September 30, 2014 compared to $41.7 million (or 36.3% of pre-tax income) for the same period in 2013. The decrease in our tax rate is principally due to reductions in state taxes and the permanent difference related to the non-taxable reversal of the contingent purchase price liability of $4.3 million. Net Income As a result of the foregoing, consolidated net income decreased $8.7 million to $64.3 million for the three months ended September 30, 2014 compared to $73.0 million for the same period in 2013. Comparison of the Nine Months Ended September 30, 2014 and 2013 Revenues Our consolidated net revenues decreased $9.3 million, or 0.5%, to $2,006.0 million for the nine months ended September 30, 2014 compared to $2,015.3 million for the same period in 2013. The decrease was the result of decreased sales in our Manufacturing/Wholesale and Franchise segments, partially offset by the increased sales in the Retail segment. Retail. Revenues in our Retail segment increased $11.9 million, or 0.8%, to $1,495.2 million for the nine months ended September 30, 2014 compared to $1,483.3 million for the same period in 2013, which was primarily driven by an increase in sales of $35.7 million in our e-commerce businesses (principally due to the acquisition of Discount Supplements which occurred in October 2013), and $37.2 million from the addition of 151 net new corporate stores and nine The Health Store locations in Ireland, acquired in April 2014. These increases were partially offset by negative domestic retail same store sales, which includes sales from GNC.com, of 2.7%, approximately $6.5 million due to the exchange rate trend of the Canadian dollar, and the negative effect due to the Gold Card giveaway associated with the Member Pricing launch in 2013. Our company-owned store base increased by 160 stores to 3,459 at September 30, 2014 compared to 3,299 at September 30, 2013, which includes 14 new Canadian stores and nine new stores as a result of the acquisition of The Health Store. Franchise. Revenues in our Franchise segment decreased $8.2 million, or 2.4%, to $327.8 million for the nine months ended September 30, 2014 compared to $336.0 million for the same period in 2013. Domestic franchise revenue increased $5.1 million primarily due to higher wholesale sales, fees, and royalties. Our domestic franchise same store sales decreased by 3.6% for the nine months ended September 30, 2014 compared to the same period in 2013. There were 1,063 domestic franchise stores at September 30, 2014 compared to 984 stores at September 30, 2013. International revenue decreased by $13.3 million, or 9.7%, for the nine months ended September 30, 2014, compared to the same period in 2013, primarily due to lower product sales, particularly due to regulatory and macro-economic factors in several key international franchise markets, partially offset by an increase in royalties and fees. Our international franchisees have reported a 1.9% same store sales increase this year, on a local currency basis. Our international franchise store base increased by 146 stores to 2,101 at September 30, 2014, compared to 1,955 at September 30, 2013. Manufacturing/Wholesale. Revenues in our Manufacturing/Wholesale segment, which principally includes third-party sales from our manufacturing facilities in South Carolina, as well as wholesale sales to Rite Aid, PetSmart, and Sam's Club, decreased $13.0 million, or 6.6%, to $183.0 million for the nine months ended September 30, 2014 compared to $196.0 million for the same period in 2013. Third-party contract manufacturing sales from our South 25-------------------------------------------------------------------------------- Table of Contents Carolina manufacturing plant decreased $6.2 million, or 6.0%, to $97.2 million for the nine months ended September 30, 2014 compared to $103.4 million for the same period in 2013. Wholesale revenue decreased $6.8 million, or 7.3%, due to lower shipments to our wholesale customers from softer market trends. Cost of Sales Cost of sales, which includes product costs, costs of warehousing and distribution and occupancy costs, decreased $4.2 million, or 0.3%, to $1,246.0 million for the nine months ended September 30, 2014 compared to $1,250.2 million for the same period in 2013. Cost of sales, as a percentage of net revenue, was 62.1% and 62.0% for the nine months ended September 30, 2014 and 2013, respectively. Selling, General and Administrative ("SG&A") Expenses SG&A expenses, including compensation and related benefits, advertising and promotion expense, other SG&A expenses including amortization expense, increased $19.4 million, or 4.9%, to $410.9 million for the nine months ended September 30, 2014 compared to $391.5 million for the same period in 2013. These expenses, as a percentage of net revenue, were 20.5% and 19.4% for the nine months ended September 30, 2014 and 2013, respectively. Compensation and related benefits. Compensation and related benefits increased $6.0 million, or 2.5%, to $245.9 million for the nine months ended September 30, 2014 compared to $239.9 million for the same period in 2013. The increase in compensation and related benefits was primarily due to support for our increased store base and sales volume, partially offset by the reversal of incentive and non-cash stock-based compensation accruals. Advertising and promotion. Advertising and promotion expenses increased $5.9 million, or 11.1%, to $59.4 million for the nine months ended September 30, 2014 compared to $53.5 million for the same period in 2013. Advertising expense, as a percentage of net revenue, was 3.0% and 2.7% for the nine months ended September 30, 2014 and 2013, respectively. The increase in our advertising expense as a percentage of net revenue is principally due to increased media advertising related to the Beat Average™ marketing campaign and the acquisition of Discount Supplements, which occurred in the fourth quarter of 2013. Other SG&A. Other SG&A expenses, including amortization expense, increased $7.5 million, or 7.6%, to $105.6 million for the nine months ended September 30, 2014 compared to $98.1 million for the same period in 2013. This increase principally relates to expenses from our newly acquired retail businesses and higher legal expenses. Other Management realignment. For the nine months ended September 30, 2014, we incurred $7.5 million associated with the changes among our executive leadership team. This expense related principally to $5.7 million in executive severance, $0.5 million of accelerated non-cash stock-based compensation expense net of forfeitures, and $1.3 million for the recruiting and hiring of new executive leadership. International franchise receivable reserve. For the nine months ended September 30, 2014, we recorded a $4.4 million reserve against receivables with our international franchisees, compared to $0.4 million for the same period in 2013. The collectability of receivables principally from one international franchisee has become uncertain due to its current financial condition. Reversal of contingent purchase price. During the nine months ended September 30, 2014, it was determined that certain conditions required to be met by the seller in the purchase agreement of Discount Supplements were not achieved, and as such, we reversed a $4.3 million contingent purchase price liability. Other (income) expense, net. Other (income) expense, which includes the gain on sale of corporate owned stores to franchisees and foreign currency (gain) loss, increased $8.5 million to a gain of $9.5 million for the nine months ended September 30, 2014 compared to a gain of $1.0 million for the same period in 2013. The increase in other (income) expense is a result of more conversions from corporate stores to franchise stores for the nine months ended September 30, 2014 compared to the same period in 2013. Operating Income As a result of the foregoing, consolidated operating income decreased $23.2 million, or 6.2%, to $351.0 million for the nine months ended September 30, 2014 compared to $374.2 million for the same period in 2013. Operating 26-------------------------------------------------------------------------------- Table of Contents income, as a percentage of net revenue, was 17.5% and 18.6% for the nine months ended September 30, 2014 and 2013, respectively. Retail. Operating income decreased $13.6 million, or 4.7%, to $277.9 million for the nine months ended September 30, 2014 compared to $291.5 million for the same period in 2013. The decrease in operating income was negatively impacted by higher media spend and expense deleveraging associated with negative same store sales, partially offset by a higher gross margin and the Reversal of Contingent Purchase Price. Franchise. Operating income increased $4.9 million, or 4.2%, to $121.6 million for the nine months ended September 30, 2014 compared to $116.7 million for the same period in 2013. The increase was due to higher gross profit margin and the gain on sale of corporate owned stores. Manufacturing/Wholesale. Operating income decreased $7.5 million, or 9.8%, to $69.4 million for the nine months ended September 30, 2014 compared to $76.9 million for the same period in 2013. The decrease in operating income was generally due to lower shipments to wholesale customers from softer market trends as well as lower proprietary sales. Warehousing and distribution costs. Unallocated warehousing and distribution costs decreased $0.4 million, or 0.9%, to $50.3 million for the nine months ended September 30, 2014 compared to $50.7 million for the same period in 2013. The decrease was primarily due to transportation savings related to the transition to a third-party pooled transportation network during the fourth quarter of 2013. Corporate costs. Corporate overhead costs decreased $0.1 million to $60.1 million for the nine months ended September 30, 2014 compared to $60.2 million for the same period in 2013, as the decrease in salaries and benefits of $4.5 million, which was principally related to the reversal of incentive and non-cash stock-based compensation accruals, was partially offset by higher legal and other SG&A expenses. Management realignment. For the nine months ended September 30, 2014, we incurred $7.5 million associated with the changes among our executive leadership team. This expense related principally to $5.7 million in executive severance, $0.5 million of accelerated non-cash stock-based compensation expense, and $1.3 million for the recruiting and hiring of new executive leadership. Interest Expense, net Interest expense increased $1.6 million, or 4.9%, to $35.0 million for the nine months ended September 30, 2014 compared to $33.4 million for the same period in 2013. This increase was due to the effects of the additional borrowings of $252.5 million under the Senior Credit Facility, partially offset by interest rate savings resulting from the repricing of the Senior Credit Facility, both of which occurred during the fourth quarter of 2013. Income Tax Expense We recognized $111.9 million of income tax expense (or 35.4% of pre-tax income) during the nine months ended September 30, 2014 compared to $123.4 million (or 36.2% of pre-tax income) for the same period in 2013. The decrease in our tax rate is principally due to reductions in state taxes and the permanent difference related to the non-taxable reversal of the contingent purchase price liability of $4.3 million. Net Income As a result of the foregoing, consolidated net income decreased $13.3 million to $204.1 million for the nine months ended September 30, 2014 compared to $217.4 million for the same period in 2013. Liquidity and Capital Resources At September 30, 2014, we had $148.2 million in cash and cash equivalents and $653.0 million in working capital, compared with $226.2 million in cash and cash equivalents and $719.0 million in working capital at December 31, 2013. The $66.0 million decrease in our working capital was primarily driven by a decrease in our cash due to the repurchase of common stock and an increase in accounts payable, partially offset by an increase in inventory levels. We expect to fund our operations through internally generated cash and, if necessary, from borrowings under our $130.0 million revolving credit facility (the "Revolving Credit Facility"). At September 30, 2014, we had $128.9 million available under the Revolving Credit Facility, after giving effect to $1.1 million utilized to secure letters of credit. 27-------------------------------------------------------------------------------- Table of Contents We expect our primary uses of cash in the near future will be for capital expenditures, working capital requirements, and funding any quarterly dividends to stockholders and share repurchases that are approved by our board of directors. In August 2014, our board of directors authorized a multi-year program to repurchase up to an aggregate of $500.0 million of our common stock. This replaces the repurchase program established in November 2013. We repurchased $230.3 million of common stock during the nine months ended September 30, 2014 and have utilized $40.0 million of the current repurchase program. On October 23, 2014, the board of directors authorized and declared a cash dividend for the fourth quarter of 2014 of $0.16 per share of common stock, payable on or about December 26, 2014 to stockholders of record as of the close of business on December 12, 2014. We currently anticipate that cash generated from operations, together with amounts available under the Revolving Credit Facility, will be sufficient for the term of the Revolving Credit Facility, which matures in March 2017, to meet our operating expenses and fund capital expenditures as they become due. We are required to make quarterly payments of $1.1 million on the amount outstanding under our term loan facility (and, together with the Revolving Credit Facility, the "Senior Credit Facility"), payable every quarter beginning March 31, 2014 and ending on December 31, 2018. Our ability to make scheduled payments of principal on, to pay interest on or to refinance our debt and to satisfy our other debt obligations will depend on our future operating performance, which will be affected by general economic, financial and other factors beyond our control. We are currently in compliance with our debt covenant reporting and compliance obligations under the Senior Credit Facility and expect to remain in compliance during 2014. Cash Provided by Operating Activities Cash provided by operating activities was $238.0 million and $216.1 million for the nine months ended September 30, 2014 and 2013, respectively. The increase was due to a decrease in receivables, the timing of payments for accounts payable, and an increase in deferred revenue and other current liabilities for the nine months ended September 30, 2014 compared to the same period in 2013. For the nine months ended September 30, 2014, inventory increased $62.5 million as a result of increases in our finished goods to support our increased store base and timing of purchase orders with a significant vendor. Accounts payable increased $8.9 million due to the increase in inventory and timing of payments. Cash Used in Investing Activities Cash used in investing activities was $61.0 million and $34.3 million for the nine months ended September 30, 2014 and 2013, respectively. Capital expenditures, which were primarily for new stores and improvements to our retail stores and our distribution center in Indianapolis, Indiana, which opened in October 2014, were $55.2 million and $33.6 million for the nine months ended September 30, 2014 and 2013, respectively. Also, in April of 2014, we spent approximately $6.4 million related to the acquisition of The Health Store. We expect capital expenditures to be approximately $70.0 million in 2014, which includes costs associated with growing our domestic square footage and our new distribution center in Indianapolis, Indiana. We anticipate funding our 2014 capital requirements with cash flows from operations and, if necessary, borrowings under the Revolving Credit Facility. Cash Used in Financing Activities For the nine months ended September 30, 2014, cash used in financing activities was $255.2 million, primarily consisting of dividends paid to Holdings' stockholders of $43.3 million and the repurchase of an aggregate of $230.3 million in shares of common stock under the repurchase program, offset by $22.7 million of proceeds from exercised stock options, including the associated tax benefit. For the nine months ended September 30, 2013, cash used in financing activities was $263.3 million, primarily consisting of dividends paid to Holdings' stockholders of $43.3 million and the repurchase of an aggregate of $238.4 million shares of common stock under a repurchase program, offset partially by $21.2 million of proceeds from exercised stock options, including the associated tax benefit. 28-------------------------------------------------------------------------------- Table of Contents Contractual Obligations There are no material changes in our contractual obligations as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2013. Off Balance Sheet Arrangements As of September 30, 2014, we had no relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off balance sheet arrangements, or other contractually narrow or limited purposes. We are, therefore, not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. Critical Accounting Estimates Our significant accounting policies are described in the notes to our unaudited consolidated financial statements under Note 2, "Basis of Presentation and Summary of Significant Accounting Policies". There have been no material changes to the application of critical accounting policies and significant judgments and estimates since those disclosed in our Annual Report on Form 10-K for the year ended December 31, 2013. Recent Accounting Pronouncements In July 2013, the Financial Accounting Standards Board ("FASB") issued accounting standard ASU 2013-11, regarding the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. This standard requires entities to present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss ("NOL") or tax credit carryforward whenever the NOL or tax credit carryforward would be available to reduce the additional taxable income or tax due if the tax position is disallowed. This accounting standard update requires entities to assess whether to net the unrecognized tax benefit with a deferred tax asset as of the reporting date. This guidance is effective for fiscal years beginning after December 15, 2013, with early adoption permitted. We adopted this guidance during the first quarter of 2014. The adoption of this guidance did not have a material impact on our consolidated financial statements. In May 2014, the FASB issued accounting standard ASU 2014-09, which updates revenue recognition guidance relating to contracts with customers. This standard states that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This standard is effective for fiscal years beginning after December 15, 2016. We are currently evaluating the impact this guidance will have on our consolidated financial statements. In June 2014, the FASB issued accounting standard ASU 2014-12, which updates guidance on performance stock awards. The update states that for any award that has a performance target that affects vesting and that could be achieved after the requisite period, that performance target should still be treated as a performance condition. This standard is effective for fiscal years beginning after December 15, 2015. We are currently evaluating the impact this guidance will have on our consolidated financial statements. |