A small toiletries company thrives by selling products the big guys don't want. By Thomas M. Anderson, Contributing Editor April 30, 2007 If we were headed for a recession, would you stop buying mouthwash or shampoo? Probably not. The need to restock your medicine cabinet and shower caddy sustains companies that make everyday health products, even if the rest of the economy slows. Huge firms, such as Procter & Gamble, Johnson & Johnson and Colgate-Palmolive, dominate the consumer-products industry. Yet they must sell billions more every year to produce a modest growth rate that will keep investors interested. That's why it's refreshing to see Chattem, a small maker of over-the-counter remedies, run with giants several hundred times its size. The Chattanooga company survives because it lavishes attention on products that the big guys discard or ignore. Its top brands include Gold Bond foot powder, Icy Hot pain-relieving cream and Selsun Blue dandruff shampoo. Chattem's focus on niche markets translates into high gross margins (sales minus cost of goods sold, divided by sales) of more than 70%. "Procter & Gamble is obviously going to spend its time on the billion-dollar brands," says Chattem chairman Zan Guerry. "We're the specialist in $20-million to $100-million brands." Lucky break Sometimes, Chattem's monster rivals throw it a bone. For example, the company bought five brands from Johnson & Johnson for $410 million in January; JJ needed to sell them to gain regulatory approval for its purchase of Pfizer's consumer health-care products division. The Chattem sale included Act fluoride mouthwash, Balmex diaper-rash ointment, Cortizone anti-itch cream, Kaopectate diarrhea treatment and Unisom sleep aid. Says Guerry: "Usually, we never get to look at brands like that." Advertisement So far, Chattem has taken over the marketing and sales functions of the brands acquired from JJ without a glitch, says William Blair analyst Jon Andersen. He expects profit margins to increase as the company brings production in-house. Plus, Chattem can generate more earnings in the future through brand spinoffs, Andersen says. The company used similar tactics to raise sales and profits after it bought Selsun Blue from Abbott Laboratories in 2002. Opportunity comes with added costs. Chattem will spend more than $20 million this year (roughly 5% of expected sales) to promote the new brands. Moreover, it issued $125 million in convertible notes to cover the acquisition cost, a move that could double the amount the company spends on interest expenses, estimates Standard & Poor's analyst Loran Braverman. Still, she forecasts that the acquired brands could boost earnings per share by as much as 30 cents in the fiscal year that ends next November. Demographics give sales of Chattem products a tailwind. As 78 million baby-boomers move toward their sixties, the market for over-the-counter treatments will enter its golden years, too. "I think there will be more dry skin, more sleepless nights and more aching backs," Guerry says. "And that will fuel our growth." Long-term Chattem shareholders aren't losing sleep over their investment. The stock (symbol CHTT) rose 450% over the past five years, to $53 in mid March. It trades at 19 times estimated fiscal 2007 earnings. Braverman thinks the stock is worth $61 and rates it a "buy."