Blackmores and the marketing arms race

If you're ever outed as a peddler of quack remedies, you have two options. The first is to throw up your hands, admit the error of your ways and promise to do better. The second is the Blackmores way: ignore your critics and peddle like you've never peddled before.

These days, the peddling is easier too. Australians have never been more in love with vitamins and supplements. In 1993, 49% of the population were said to regularly use complementary medicines but it's now closer to 70%.

Few companies have benefited from this trend more than Blackmores – Australia's largest supplement maker – with sales tripling over the past decade to $561m.

That's stranger than it seems. Without the protection of patents, Blackmores has little to differentiate its products, and there's less regulation of the industry compared to prescription drugs, which makes for lower barriers to entry.

Such strong growth also hides the embarrassing lack of evidence that many of Blackmores' products even work. Only a handful of vitamins have been found to have a positive effect, including zinc and folate, but the majority have no reliable evidence to show they're effective – and some, including vitamin E, may even increase mortality (for a list of which supplements are useful – and which are bogus – check this Harvard-backed scorecard).

Exaggerated claims are endemic in this industry. There are 12,000 complementary medicines currently on Australian shelves and, in 2016, the industry regulator – the Therapeutic Goods Administration (TGA) – conducted 551 reviews to check products were compliant with guidelines, using a mix of targeted and random spot checks.

That manufacturers pulled 74 of these products from the shelves as soon as the TGA requested information says something itself. The scary part, however, is that of those products where a compliance outcome was determined, 80% failed – mainly due to incorrect labeling and companies not holding efficacy data to back up their claims.  

We don't know how many of Blackmores' products were sampled, if any, but the lack of clinical evidence to support supplement sales still makes it a unique growth story.

Who needs research?

In 2017, Blackmores spent $3.6m on research and development (R&D), or around 0.6% of revenue. Compare this to CSL, which invests 9% of revenue into research, or Cochlear which manages 12%. Sirtex Medical spends six times more on R&D than Blackmores, despite having half the revenue.

Blackmores isn't a traditional healthcare company, whose sales are based on building more effective products and therapies. At its core, Blackmores is a marketing machine. Blackmores spends on R&D in a year what it spends on marketing every 25 days – a total of $51.1m in 2017.

This isn't to single out Blackmores. The company's main competitor, Suisse, also spends around $50m a year on marketing, and a preference for marketing over R&D is the industry norm.

However, the trouble with marketing-driven business models – without the science to back them up – is that they encourage one-upmanship among competitors for who can make the biggest, day-dreamiest claims. ‘Your vitamin A helps with skin disorders? Well ours will give you night vision' (no joke, check out Blackmores Vitamin A 5000).

As competitors stretch to make the most enticing claims, they're more likely to run into trouble with regulators if they don't have the data to support their case. The alternative is to moderate the claims, but then fall behind the competition.     

If you look in the right places, it's clear where Blackmores' priorities lie. On page 8 of the company's 2017 sustainability report, you'll find a list of 15 areas of materiality. Research ranked fourth on a scale of how impactful it is to Blackmores' business – and dead last on importance to employees and shareholders. The only other categories that were considered impactful from a business perspective but of little relative importance to stakeholders were anti-corruption and product compliance. The things considered most important? The supply chain and business performance.

Over the past five years, Blackmores' R&D spending has almost halved, while the sales and marketing budget has more than doubled.

One-way bet

Shareholders, however, probably have little to worry about. Most customers don't have the ability or inclination to distinguish between evidence-backed medicines and imposters. In February, a Four Corners exposé that was highly critical of Blackmores, and a few negative news reports that followed, barely made a dent on sales.

The TGA is also painfully underfunded, so tests less than 5% of supplement products for compliance each year and can't keep up with industry growth. Some 12,000 supplements are on Australian shelves, with 1,600 being added a year.

The only registration requirement for new supplements is to fill an online form and tick a box that you have data to back up your claims. It's a one-way bet because by making a false claim you benefit from stronger sales, whereas if you're caught by the TGA all you receive is a warning letter or have the product de-registered. This encourages companies to design as many different products as possible, with the wildest claims they think they can get away with – exacerbating the hapless game of whack-a-mole facing the TGA.

The trouble with Blackmores being a marketing company, rather than an evidenced-based drug maker, isn't regulatory risk – it's that sales are discretionary. The value of its products is mainly perceived, not real. That doesn't mean it can't sell lots – the company has been around for 87 years and sales are close to all-time highs. But offering perceived, rather than real, value to customers means marketing companies can, and do, fall out of favour. Blackmores' sales stagnated for four years in the mid-1990s and the stock lost half its value.

If Blackmores only sold vitamins, it would have meagre returns on capital and wafer-thin margins like most of its foreign competitors. What it really sells is trust and that gives it a healthy profit margin of 11% and an outstanding return on equity of 35% – but trust always seems rock solid, until it is lost.

Volatility rising

The bigger risk, though, may be Blackmores' overseas expansion. The company is pushing aggressively into Thailand, Malaysia, Taiwan, Hong Kong, Singapore, and China. As a proportion of total revenue, Australian sales have fallen from 80% to around 60% over the past five years (see Chart 1). Asian consumers now account for almost half the company's total sales if you include the army of Chinese entrepreneurs – known as  'daigou shoppers' – buying Blackmores' products at local retailers and shipping them to China at a large mark-up.

When someone walks into an Australian pharmacy and hands over $60 for a jar of ‘Royal Jelly' capsules, it's trust and brand loyalty that allows Blackmores to charge a premium price. With less overseas brand recognition, Chinese and other Asian customers are likely to be more sensitive to marketing mishaps and willing to switch to cheaper brands when economic conditions deteriorate. As far as sales go, it's been smooth sailing for a few years now, but risks are building as sales are increasingly sourced from developing countries.

Blackmores undoubtedly has plenty of growth potential – at home and overseas – a clean balance sheet, strong brand, and economies of scale. None of this, however, removes the risk of growing volatility in sales, and a marketing-driven business model reliant on brittle consumer trust. With a forward price-earnings ratio of 38 based on consensus estimates for 2018 earnings, the stock is pricing in considerable growth and offers no margin of safety. We're downgrading to SELL.