It's important for long-term investors to develop a guide for doing their investment research. Over the years I have developed questions to guide me in my thinking when researching the publicly traded universe. These questions represent a good starting point before doing more in depth research. Right now let's talk about Arctic Cat (NASDAQ: NASDAQ:ACAT).
1.) What does the company do?
When you buy shares in a company you effectively become part owner of that company. Therefore, it's important for an investor to understand what a company sells. Arctic Cat makes and sells snowmobiles, all-terrain vehicles and side-by-side recreational off-highway vehicles.
2.) What do the fundamentals look like?
Investors should also look for companies that grow revenue and free cash flow over the long-term, retaining some of that cash for reinvestment back into the business and for economic hard times. Excellent revenue and free cash flow growth serve as catalysts for superior long-term gains. Over the past five years, Arctic Cat expanded its revenue 52%. However, its net income and free cash flow declined 95% and 155%, respectively (see chart below). Essentially, Arctic Cat hit a fundamental brick wall in its FY 2015 due to a product recall. The associated legal fees, warranty expenses and executive transition costs hurt fundamental comparisons during this time.
ACAT Revenue (TTM) data by YCharts
Arctic Cat is off to a rough start in its FY 2016. In the most recent quarter, the company saw its revenue decline 6% year-over-year. The company swung to a net loss of $1.1 million vs. a net income of $3.6 million the same time last year. Arctic Cat also swung to a free cash flow deficit of $51 million vs. $4.7 million the same time last year. Inventory reductions at the dealer level put a dent in top line growth. Arctic Cat's management said this was planned, but it has an underlying implication that consumers' demand for its products are lacking due to the recall notice. It also indicates damage to its brand. The willful decline in the top line filtered down into the bottom line and cash flow.
Arctic Cat possesses a decent balance sheet. In the most recent quarter, the company possessed $20 million in cash, representing 11% of its stockholder's equity. I prefer to see companies with cash amounting to 20% or more of stockholder's equity to get them through tough times, self-finance research and development and support its dividend. I don't like long-term debt. It creates profit choking interest costs. I like to see companies with long-term debt amounting to 50% or less of stockholder's equity. Arctic Cat only possessed long-term debt amounting to 17% of stockholder's equity.
Arctic Cat does pay a dividend. I like to see companies pay out less than 50% of their full year free cash flow in dividends. Last year, Arctic Cat paid out a prudent 17% of its free cash flow in dividends. Currently, the company pays its shareholders $0.50 per share translating into an annual yield of 2%.
Arctic Cat's solid fundamentals between the last recession and the recall rewarded the company's long-term shareholders with a total return of 214% vs. 97% for the S&P 500 over the past five years (see chart below). However, these superior returns may not last if Arctic Cat can't get things back on track.
ACAT Total Return Price data by YCharts
3.) How much management-employee ownership is there?
Investors should always look for businesses where the managers and/or employees own a lot of stock in the company. Managers with a great deal of stock in the company will take better care to maximize company profits, which will enhance share price and their personal wealth along with the wealth of shareholders. According to Arctic Cat's latest proxy, no executive or employee owns more than 1% of the company, meaning that these executives don't possess significant extra incentive.
4.) How does its "Report of Independent Registered Public Accounting Firm" stack up?
Every year a company employs external auditors to audit financial statements and evaluate whether it maintains adequate financial controls. At the conclusion of the audit, you want to see a letter from auditors with the language "unqualified" or "fairly presents", which generally means that the financial statements and internal systems in constructing them were clean or adequate. If you see "qualified" or "adverse" in the auditing letter's language then deeper issues in a company's financial statements may exist. Last year Arctic Cat's auditors gave its financial statements an "unqualified opinion" and said the company maintained adequate internal controls.
5.) What types of risk does it have?
It's always important for investors to weigh the various risks such as exposure to political risk in parts of the world where war is the norm, competitive positioning, and market price risk. Arctic Cat does operate globally in places like China and Russia, which means the company is exposed to political risk.
Arctic Cat competes most directly with Polaris Industries (NYSE: PII), which does a better job of keeping costs under control and generating free cash flow (see charts below). Moreover, Polaris Industries doesn't currently possess a brand damaged by a recall like Arctic Cat. However, Polaris Industries isn't immune to possibilities of a recall either.
ACAT Operating Margin (TTM) data by YCharts
ACAT Free Cash Flow (TTM) data by YCharts
Arctic Cat trades at a forward P/E ratio of 28 vs. 18 for the S&P 500, according to Morningstar, meaning that this company's market price risk resides a little in the high range. Any earnings disappointment will most likely cause a major correction in Arctic Cat's stock price.
6.) What does its forward analysis look like?
Arctic Cat is down, but it's not out. The company's new CEO wants to cut costs, come out with new products and rebuild the company's brand. Artic Cat has its work cut out for if it wants to make customers forget about the issues surrounding the recall. Also, Arctic Cat wants to de-emphasize snowmobiles a little, from its current 43% of sales to 37% of sales by FY 2020.
While, understandably, the company wants to slowly shift to products less prone to weather volatility, snowmobiles represent the company's traditional core competency. Proper execution of its turnaround plans represents the key to future superior returns for company shareholders.