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Chattem's New Shine

By Howard Choe Personal-care products maker Chattem (CHTT

; recent price, $28) -- the name behind Selsun Blue dandruff shampoo and Gold Bond foot powder -- is experiencing a strong turnaround after posting modest results in the second half of fiscal 2003 (ended November). Standard & Poor's Equity Research believes an increased focus on new products and effective cost controls are driving this rebound.

Given what we see as a positive outlook for growth and attractive valuation, we believe Chattem is well positioned to significantly outperform the S&P 500-stock index over the next 12 months. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or buy.

We believe the main catalyst for growth over the next several years will be product innovation. Chattem has increased its focus on new product development, having built a 10,000-square-foot research and development center and adding seasoned industry specialists from leading consumer-product companies to its staff. Chattem plans three to five new products annually in future years. It introduced seven new products in fiscal 2004 that are expected to account for 10% of net sales. The success of these new products has contributed to the solid 8% increase in net sales for the six months ended May 31, 2004.

WEARABLE RELIEF. Chattem's products include over-the-counter (OTC) health-care, toiletries, and skin-care products, which are distributed nationally through food, drug, and mass merchandisers. The company has five reporting segments: topical analgesics (26% of fiscal 2003 sales) featuring the Icy Hot, Aspercreme, and Flexall brands; medicated skin-care products (24%) featuring Gold Bond powders, creams, and lotions and Phisoderm acne treatments and cleansers; dietary supplements (16%), including the Dexatrim, Garlique, and New Phase brands; Selsun Blue Medicated dandruff shampoos and conditioners (12%); other products (12%), including Pamprin menstrual analgesics, Herpicin-L lip treatment, and Bullfrog sunblocks; and International (10%). With a diversified product portfolio, no single brand accounted for more than 15% of sales in fiscal 2003.

Chattem also has a diversified distribution base. Sales to its top 10 customers, which include Wal-Mart (WMT), Walgreen (WAG), and Kroger (KR), constituted approximately 67% of total fiscal 2003 sales. Sales to Wal-Mart accounted for 34% of 2003's total, and no other customer accounted for more than 10%. By channel, mass retailers contributed 40% of fiscal 2003 sales, drug 29%, food 24%, and other 7%.

One of the most innovative products recently introduced, in our view, is the Icy Hot Sleeve, a woven knit embedded with an over-the-counter pain reliever, designed to fit comfortably over painful joints for those suffering from arthritis, bursitis, tendonitis, or muscle aches. This product has been backed by effective advertising featuring Los Angeles Lakers star Shaquille O'Neal. Icy Hot Sleeve has experienced strong sales to retailers. Given strong patent protection and the complex manufacturing process for Icy Hot Sleeve, we believe Chattem will face few competitive challenges for this niche product in the near term.

DESIGNATED DRIVERS. Other new products that have shown promise, in our opinion, are the All-in-One Dexatrim bar (a combined diet and energy bar), Selsun Blue conditioner, Icy Hot back patch, and Gold Bond Ultimate Healing Skin Therapy Lotion.

Additional catalysts for sales growth, in our view, are attractive demographics (Chattem's products largely serve the aging and physically active population), increased distribution at retailers, and its entrance into new global markets. Chattem has a goal of increasing international sales to between 15% and 18% of the total in three to five years, up from the current 10%. Given these potential drivers, we believe Chattem is well positioned to increase sales at the high end of its personal-care peers. We expect sales to increase approximately 13% in fiscal 2004, largely reflecting strong results for new products.

We believe that Chattem, which already maintains the highest operating margin among the household/personal-care outfits we cover, at 23.9% (fiscal 2003), is likely to continue expanding margins over the next several years. We expect it to leverage its increased sales and continue to extract cost savings along with other acquisition synergies. In March, 2002, Chattem acquired Selsun Blue from Abbott Laboratories (ABT

; S&P ranking, 4 STARS, or accumulate; $41) and consolidated manufacturing facilities worldwide.

NUMBER CRUNCH. As of May 31, 2004, Chattem had $10.9 million in cash and $200 million in total debt, down from $216 million in the year-ago period. It has been paying down debt and arranged refinancing this past March that yielded $3.7 million in aftertax savings, or 19 cents a share.

We expect earnings per share to advance 40% in fiscal 2004, to $1.67, from $1.19 in fiscal 2003. We anticipate a further rise of 12% in fiscal 2005, to $1.87. We project fiscal 2004 S&P Core Earnings of $1.46 a share, mainly reflecting the impact of estimated stock-option expense.

We believe cash flows are ample for debt servicing and funding other activities, such as share repurchases. We're projecting Chattem's cash flow from operations to increase 24%, to $39 million, in fiscal 2004. Assuming capital spending of $5 million, we project free cash flow of $34 million in fiscal 2004, up 31%. Chattem converted approximately 11% of revenue to free cash flow, in line with our personal-care universe.

HIGH QUALITY. Free cash flow is also used to buy back stock, as Chattem repurchased 360,000 shares, for a total cost of $5.4 million, in fiscal 2003 and 129,000 shares, for $3.2 million, in the six months ended May 31, 2004. A balance of $16.8 million out of a total authorization of $20 million stood at the end of May.

We estimate the ratio of Chattem's earnings before interest, taxes, depreciation, and amortization, or EBITDA, to the amount necessary to cover interest charges to be 4.5 times for fiscal 2004. The household and personal-care average over the past three years is about eight times. Although Chattem is below the total average, it's at the high end for small-cap companies. In addition, S&P's debt-rating department has a stable outlook with a B+ rating on Chattem.

We believe the quality of Chattem's earnings is high relative to its peers. After a series of adjustments made to net income from continuing operations (based on generally accepted accounting principles, or GAAP) and before extraordinary items to conform to S&P Core Earnings methodology, the company's fiscal 2003 net income per share of $1.19 would be reduced by 13%, to $1.03. This percentage difference compared favorably to the average 17% negative variance for our personal-care companies universe.

For fiscal 2004, we're projecting S&P Core EPS of $1.46, also a 13% reduction from our operating EPS estimate of $1.67. The reduction for option expense accounts for 20 cents of the difference, while a debit for a pension adjustment accounts for 1 cent.

HITTING THE TARGET? In our view, the stock is attractively valued at a recent level of 15 times our fiscal 2005 EPS estimate, a 25% discount to the average p-e of our personal-care product coverage universe, and a 25% discount to our estimate of intrinsic value (determined by

discounted cash-flow, or DCF).

Based on our DCF value and our target p-e ratio of 19 for estimated fiscal 2005 EPS, we arrive at a 12-month target price of $35, approximately 25% above recent price levels. In light of this assessment, we believe the shares will significantly outperform the S&P 500.

Potential risks to our investment recommendation and target price, in our view, include: litigation related to injuries or illness stemming from the ingestion of dietary supplements; costly changes in connection to regulatory compliance; integration risk stemming from acquisitions; and low market acceptance of new products. Analyst Choe follows stocks of personal-care products companies for Standard & Poor's Equity Research Services

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