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MagicDiligence (< 20)

Matrixx Initiatives (MTXX) - An Investing Parable

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August 06, 2009 – Comments (0) | RELATED TICKERS: MTXX.DL

Matrixx Initiatives (MTXX) might as well be renamed Zicam, Inc. The company makes and markets over-the-counter remedies in the following categories: Zicam Cold Remedy (68% of sales), Zicam Allergy Relief (17%), Multi-Symptom Cold and Flu (11%), Cough (4%), and a very small amount from recently launched antacid product Xcid.

This is a cautionary tale, a lesson learned - a parable of investing, if you will. Not long ago Matrixx Initiatives was an attractive looking investment. The Zicam brand had been gaining market share for years in the huge and crowded cold/flu/allergy over-the-counter market, a $4 billion dollar industry. Growth prospects were at least decent, as the launch of Zicam into Canada had been successful, Xcid had been launched, and the company maintained a strong, debt-free balance sheet to take advantage of any opportunities to acquire OTC brands that had to be jettisoned due to FTC requirements of large pharmaceutical company mergers. Revenues were growing at 20% year-over-year rates. Returns on capital were and are outstanding, averaging 26% on a real ROIC basis, and 73% on an MFI basis. It looked like a solid pick for a MagicDiligence Top Buy.

Many investors know what happened next. In mid-June, the FDA issued a warning that Zicam nasal gel and swabs could cause anosmia, a condition leading to loss of smell, sometimes permanently. The warning directly applies to about 40% of Matrixx's business, but the damage is worse than that. With a rather fixed cost structure, the hit would be far worse than 40% of profits, and since Matrixx uses primarily a single-brand strategy, the collateral damage will surely extend to the Zicam products that are orally ingested as well. In the consumer's mind, Zicam = bad, regardless of what type of product. Matrixx initiated a recall of its nasal products and announced their intention to discuss the issue with the FDA. But, like cowboys say, "you can't put the [crap] back in the horse". Despite any logical arguments, the damage has been done. The actual occurrence of anosmia claims has been about 3-5 per 100,000, which is pretty small. In cases like this, perception is reality.

The lesson is this: make sure there are no identifiable and reasonable risks that can destroy a large part of a business before investing. Looking back, there were red flags around Matrixx. The anosmia claims had been going on for years, but Matrixx had won every case that went to court, and the frequency of cases had been dropping significantly from a high in 2005. However, while cases like this are just a nuisance to large, diversified OTC producers, to small single-brand outfits like Matrixx they are life-and-death fights. There was a black cloud over the executive suite too... former CEO Carl Johnson abruptly resigned last October with no stated reason. Too many risks... in hindsight.

At this point, there is no reason for MFI investors to consider Matrixx. Its ridiculous 170% earnings yield and 117% MFI return on capital are gaudy screen values, but they are mirages. The class action lawsuits are piling in - I count 9 new ones in the past 3 weeks alone. Imagining a Matrixx with a cost structure for $100 million in sales bringing in about $40 million is difficult enough, but then consider that the company will spend tens of millions defending or settling lawsuits on top of that. The balance sheet is strong, with $40 million in net cash, but it won't be for long. In the very best case, Matrixx comes out of this a smaller company. In the worst case, they run out of cash and go insolvent. Avoid this one.

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