Camping World Is High Risk/High Reward

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About: Camping World Holdings, Inc. (CWH)
by: Somint Research
Summary

There are quite a bit of liabilities on the balance sheet that should make investors cautious about their views of CWH.

A deep recession will cause a bad outcome for the stock, but CWH is well prepared to deal with a slowdown.

A full recovery of RV sales in 2019 appears unlikely given the most recent trends, but that doesn't mean a doomsday scenario that would wipe out the stock.

CWH has other sources of revenue that complement the business and generate enough growth to make up for weak vehicle sales.

Even though I believe Camping World Holdings (CWH) is a good opportunity with strong upside potential, it would be foolish to ignore that this upside potential also comes with quite a bit of downside risk. I expect CWH to do well in the long run. However, based on current trends in RV sales and RV shipments, coupled with a high level of financial leverage, it is possible that CWH's stock goes lower before it shines.

This article explores recent trends in the core RV business, and ties those trends with the composition of the balance sheet to bring awareness to investors on the level of risk/reward that CWH offers.

Source: Gander RV website

Let’s start with the balance sheet

One of the main reasons for me to classify CWH as high risk/high reward is its financial leverage. More specifically, double leverage on inventory and corporate debt should cause the stock to be quite volatile. CWH finances a good amount of RV inventory with floor plan debt, which, in combination with corporate debt, creates a company that is highly leveraged.

In addition to floor plan and corporate debt, new US GAAP standards requires CWH to capitalize operating leases on the balance sheet, which quantifies this liability and adds to financial leverage. So on top of corporate debt and floor plan, CWH has capitalized financial commitments that increases the risk of the stock.

Don’t get me wrong, financial leverage will improve returns for equity investors when things go well. But it works the same way when things don’t go well.

The next two images show a summarized version of the right (assets) and left side (liabilities + equity) of the balance sheet.

In order to eliminate the noise of smaller (and less relevant) line items, I present a summary of assets and liabilities.

Source: Company filings, Author’s computations and labels

Other current assets = contracts in transit + receivables + prepaid expenses & other assets

Other LT (tangible and intangible) assets = DTAs + intangible assets + goodwill + other assets

The point is most of CWH's assets are concentrated in inventories (most of which are RVs) and operating leases. Additionally, it’s important to note cash on hand is a very small portion of assets, which means there isn’t much of a cushion to hold the value of the stock if a deep recession occurs (RV sales will probably fall drastically during a deep recession).

By looking at the left side of the balance sheet, it is easy to notice most of CWH's assets are financed with debt.

Source: Company Filings

Current portion of leases & debt = current portion of finance leases + current portion of operating leases + current portion of long term debt

Other liabilities = accounts payable + accrued liabilities + deferred revenues + current portion of TRA + other current liabilities

Other LT liabilities = TRA liability + deferred revenues + other LT liabilities + right to use asset

Even though book value (for CWH) is not a relevant valuation metric in this case, that it amounts to only $8M (or ~$0.1 per share) is a sign the balance sheet is stretched.

There are three main items to highlight from the left side of the balance sheet, all of which make the stock a risky one.

First and most importantly, floor plan accounts for $882M, or approximately 55% of total inventory. And it is due fairly soon because it finances RV inventory (hence classified as current). With only ~$70M of cash on hand, CWH's health is highly dependent on converting its inventory into cash in order to repay its floor plan. Not having a cash cushion makes the stock a much higher risk if RV sales take a big slump.

More importantly, floor plan debt is likely priced on the short end of the yield curve (since they’re shorter-term loans). Therefore, its interest rates have risen (not fallen like the recent move in US 10-year rates) as shown in the graph below. To this benchmark rate add a spread of 2.1-2.5% and that’s the total cost of the floor plan.

Source: CWH filings (10-Qs and 10-Ks)

The nice thing about floor plan financing is that it may pay no interest if inventory turns fast (30 days I believe), which usually happens in the right economic environment. But if inventory doesn’t sell fast enough, the cost of carrying financed inventory at rising interest rates would cause a big earnings slump. As we all know, earnings slumps are not good for stocks.

The second issue with the left side of the balance sheet is operating lease liabilities are large relative to total liabilities. The good thing is this is due over time as it represents the present value of future rent payments. In other words (and with some calculation nuances), lease liabilities is the accumulated value CWH will pay in rent to lease the real estate needed for RV dealerships and retail locations. This “debt” is not terribly concerning because CWH is covering occupancy costs out of revenue (occupancy cost is the cash interest equivalent on operating lease debt).

The third issue is the relatively large corporate debt that amounts to ~31% of liabilities. The bulk of this isn’t due until November 2023, so this debt shouldn’t cause a big liquidity issue in the near term as required principal payments are ~$12M per year and it carries a manageable interest of ~5.25% (although it is variable). Corporate debt amounts to ~3.5x of Adjusted EBITDA guidance for 2019. That level is probably a bit high for the highly cyclical operations of CWH, but it is not alarmingly high. I’ve seen much worse.

In summary, as long as occupancy costs are covered by revenues and debt is paid out of profits, the balance of profits should accrete to equity owners. The biggest risk is floor plan debt, and that could cause a liquidity issue if RV sales take a massive hit during a deep recession. But I believe CWH has a strong business, and it will be able to generate enough revenues and profits to meet all financial obligations.

Let’s look at the drivers of revenues and profits to see if they can cover these liabilities.

Operating trends of CWH

Things get a little trickier because even though CWH is generating enough profits to cover all liabilities, the trend has turned the corner and isn’t looking great.

Total RV sales are not only slowing for CWH, but it actually declined in Q1-2019. That’s an inflection point and probably the number one reason for the stock to be trading around its 52-week low. Total vehicle sales decline not a great sign when a big chunk of the inventory is financed with floor plan debt.

The table below shows the latest quarter sales trend:

Source: Company Filings (10-Q)

The table below shows the yearly trend in RV sales.

Source: Company Filings (10-K)

Vehicle sales represent the majority of revenues for CWH, typically accounting for ~70% of revenue. Vehicle sales is by far the most important component of the business. To see a decline in total vehicle sales in the last quarter is discouraging.

However, the remaining 30% of revenues (retail, parts and services, etc.) is doing well and growing at solid pace. Moreover, other sources of revenue generate higher gross profit margins and therefore are bigger contributors to profitability (as measured by EBITDA).

In the last quarter, total revenues were roughly flat as other sources of revenue made up for the decline in new vehicle sales. This is encouraging because it means CWH is able to meet its financial liabilities despite the slowdown in the core RV business. Because of the highly cyclical nature in RV sales, to have other sources of growing revenue (and at double-digit rates) is one of the main reasons to like CWH's stock.

While new RV sales is the main cash generating source to repay floor plan debt, CWH seems to have plenty of other sources of revenue to cover occupancy costs and corporate debt. That’s a key reason for me to take the risk and own the stock.

There’s no denying that profitability was challenged in the last quarter as cost increased much faster than revenue. The main cost pressure came from the SG&A line item, which is driven by the new store base as CWH opened 43 new stores on a Y/Y basis. These are mainly physical stores and dealerships, so there is a cost to having them open. These stores were probably not productive during Q1, thus the profit slump. Adjusted EBITDA fell by ~68% last quarter.

However, it is very important to keep in mind that CWH business is seasonal. And Q1 is not a critical quarter because it generates the lower sales. People just don’t buy as many RVs in Q1 (or Q4). Additionally, Q1 is also a relatively soft retail quarter as most people spent their money during holiday season (Q4).

Because Q2 and Q3 are the most important quarters for sales generation, the upcoming earnings report will probably make big moves in the stock. Be prepared. With 43 incremental new stores up and running, I think there is a good chance that we see a rebound in sales trend, and therefore the stock.

The main headwind is that we’re late in the economic cycle and there are clear signs of RV sales slowdown. But I believe CWH scale and offerings (such as Good Sam Club) provides them with a competitive advantage to gain market share despite a weak macro environment.

Investor conclusion

A long-term investor may realize that CWH's stock is already pricing RV sales headwinds, but not the potential upside if RV sales recover. Admittedly, the outlook is a bit grim, but I would argue the stock is already priced accordingly at ~6.5x this year’s expected EBITDA. And as I mentioned in my previous article, I believe this year’s EBITDA is conservative.

Given the amount of financial leverage on RV inventory and balance sheet, the stock will do terrible if RV sales take a big slump, which is possible if a deep recession occurs, but unlikely in my view. Remember that leverage also works on the upswing, and if the 43 new stores perform well, we can see a big increase in the stock.

I don’t believe in a doomsday scenario for RV sales. I am cautious about recent trends. I am mentally (and financially) prepared to see a lower stock price if RV sales don’t recover in 2019. But I think CWH can hold up and meet its financial liabilities, which will reward patient investors when RV sales turn the corner.

Disclosure: I am/we are long CWH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.