Blackmores – not quite what the doctor ordered?

Founder and Chief Investment Officer of Montgomery Investment Management
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Reporting season begins in earnest next week and some days in August will see up to 90 companies report their results for the period to 30 June. One “market darling” we haven’t owned shares in for some time, is the eighty-year old health products business, Blackmores Limited (ASX: BKL). We will be interested to see if Blackmores’ results, to be released in late August, shed light on what appear to be significant structural pressures to their business.

Acquisition issues

Despite its Asian operations now accounting for 20% of revenue and 26% of group net profit, and the company being a clear beneficiary of the recent fall in the Australian dollar, Blackmores noted in its regular quarterly update a 7% decline in net profit for the nine months to March 2013, compared to the previous corresponding period. This was troubling for a number of reasons.

Firstly, while at the top-line a reported 29% jump in revenue looks like a superb result, readers need to consider that on 2 July, 2012, BKL completed the acquisition of FIT-BioCeuticals, which came with FY11 Earnings Before Interest Tax, Depreciation and Amortisation (EBITDA) of $4.6 million, on revenue of $38 million. Backing this out, we calculate around two thirds of the FY13 sales growth as having been “acquired”, and one third – or around 10% – as organic.

Secondly, core net earnings for the nine months to March 2013 would have been down by more than 10%.

We would have expected that the aforementioned $40 million acquisition would have resulted in an immediate boost to underlying profitability, post integration. We will be looking at the FY13 results and associated commentary, to be released in late August, to better grasp the apparent decline of Blackmore’s traditional business.

Tough competition

The competitive landscape in Australia has dramatically increased in the form of Swisse, and its very aggressive marketing campaigns. Our assessment is that Swisse is out-spending Blackmores at a 6-1 ratio.

We understand that the entry of Swisse into the Australian market was initially dismissed by Blackmores, and at the time, we wondered aloud whether the incumbent had been underestimating the new kid on the block. We don’t think it is any more!

Swisse is using several high profile sporting and acting personalities under the “you’ll feel better on Swisse” slogan. Coupled with lower prices, Blackmores’ traditional positioning appears to be under threat.

Understanding pricing dynamics can reveal a great deal about the competitive advantages in an industry. If Blackmores responds to Swisse by reducing its prices, it would suggest the value of its brand is under pressure, and that there is a structural change within the Australian vitamin industry.

Distribution chain

Traditionally, Blackmores has sold a meaningful portion of its higher-margin products to pharmacies. A lot of Blackmores promotional investment was in training pharmacy assistants, rather than marketing directly to consumers, and there was little to no product discounting.

The rise of the discount pharmacy, combined with the increasing level of complementary medicine sales within supermarkets, is another tier of “structural change” threatening Blackmores’ positioning.

Both of these retail concepts work in selling high volumes on lower margins. Woolworths, Coles and Chemist Warehouse all pursue the Walmart game, whereby suppliers fund the discount in the hope of increased volumes. Chemist Warehouse, for example, often advertises discounts of 50% on certain brands or ranges of products.

Given the long shelf life of the products, a regular user can stock up when there is a sale. In Australia’s highly concentrated retail landscape, the metal of even most traditionally strong brands is being tested.

Outlook

Our assessment is that Blackmores appears strategically stuck between an aggressive competitor and a retail environment that is becoming accustomed to discounting. As one of the most recognised brands in this market, combined with its eighty-year history, Blackmores has historically enjoyed having a trusted brand name and a “market darling” status. However, it appears to us that there has been a structural shift – and we expect margin compression to continue over the medium term.

Over the past decade, the share price of Blackmores has rallied from $6.00 to peak at $36.00 in February 2013. Despite the sharp retreat in share price to its current $26.00, at Montgomery Investment Management we still aren’t sufficiently convinced that BKL is attractive for our own funds.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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