Blog Post

This article is a reprint of my August 12 2008 RealMoney column.

Sometimes you have to wait for a bit of bad news to get a stock at the price you want. I think that is the case with Chattem (CHTT) , a leading niche provider of over-the-counter health care products, toiletries and dietary supplements.

Chattem’s brands include Pamprin, Gold Bond, Selsun Blue, Dexatrim and Bullfrog. About one-third of its sales are to Wal-Mart (WMT - Annual Report) stores. Chattem’s share price has fallen more than 10% since the company was forced to recall several Icy-Hot Heat Therapy products that were providing too much heat and causing burns. With that episode resolved, I think the lower price represents a buying opportunity.

By focusing on niche market segments outside the core product areas of larger consumer product companies, Chattem has built brand equity and leveraged its distribution capabilities, which has resulted in increased profit margins. The strong brands also allow for multiple brand extensions, such as Gold Bond Restoring, Cortizone Intensive Healing, Icy Hot PM and Aspercreme Heat.

When Johnson & Johnson (JNJ) bought Pfizer’s (PFE - Annual Report) consumer products division in 2007, regulators required it to divest certain brands. Chattem swooped in. For $410 million, the company added ACT, an anti-cavity mouthwash/mouth rinse; Unisom, an OTC sleep aid; Cortizone-10, a hydrocortisone anti-itch product; Kaopectate, an anti-diarrhea product; and Balmex, a diaper-rash product. The new products increased Chattem’s revenue base by more than a third.

While such acquisition opportunities arise only occasionally, Chattem’s focus strategy and brand extensions should allow for strong organic growth as well. For 2009, the company expects organic sales to grow at a high-single-digit rate or higher. As the acquired JNJ products reached their anniversary this year, Chattem has continued to exceed earnings expectations.

For the full-year 2008, analysts have ticked their estimates up slightly, and the consensus for 2009 per-share estimates has risen from $4.47 to $4.54 over the last month. Chattem management expects the firm to generate $90 million to $95 million in free cash flow this year, which amounts to a 7.25% free cash flow yield based on the current market capitalization.

At more than twice the yield on five-year Treasuries, the cash flow offers investors both a risk premium and a margin of safety. The cash is also being put to good use. So far this year, the company has repurchased 418,000 shares at an average price of about $63 a share. The company also reduced its total debt load by $50 million over the last year. The risk premium is further enhanced by the 15% earnings growth expected over the next three to five years. That growth rate is below the sustainable rate based on ROE, and given the company’s history of share repurchases, I think there could be room for upside EPS surprises.

I don’t see the need for such a high free cash flow yield when the cash flow is growing so quickly. When you combine 15% annual growth with a 6.3% terminal free cash flow yield (100% of the current Treasury yield), you get the equivalent of 18.5% annual returns over the next five years.

Investors have awarded Chattem an average P/E ratio of 20.7 over the last five years. If shares trade back up to that historical multiple, then you are looking at 30% to 34% share price appreciation, based on 2009 estimates. That multiple of the $4.54 consensus 2009 estimate suggests the shares could increase 34% to $94 a share over the next year or so.

Disclosure: At time of publication, William Trent has no financial position in the companies mentioned in this article.