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Margin Expansion And Sales Rebound Not Priced In For VSTO

|Includes: Vista Outdoor Inc. (VSTO)
Summary

Sales and margins should rebound due to bottoming out of ammunition sales and decreased commodity input cost pressures.

The balance sheet should look a lot healthier after non-core assets are sold.

Heavy insider buying in the $13-15 range.

Company Background

Vista Outdoor (NYSE:VSTO) spun off from Orbital ATK, a supplier of military equipment, in 2014 and is a global manufacturer of consumer products in the outdoor sports and recreation markets. VSTO operates in two segments: Outdoor Products (cycling and hiking gear, paddleboards, outdoor cooking solutions, firearm accessories) and Shooting Sports (ammunition and firearms for retail and ammunition for law enforcement), both of which account for 50% of total sales in fiscal 2018 (ending on March 31). Revenues from the Shooting Sports segment have historically been the majority of total sales, 76% back in 2014. VSTO has grown through a series of acquisitions within Outdoor Products. The company has recently decided to sell a bunch of assets within Outdoor Products, as well as the firearm business within Shooting Sports. I believe this will take VSTO back to its roots and help concentrate efforts and resources on ammunition sales.

Recent Events Causing Stock Price to Drop

Stock dropped from over $50 to around $16. The demand for ammunitions and firearms is fear driven. When there is threat of gun control, consumers stock up on products in response to possible supply constraints in the future. Obama was labeled as the greatest gun salesman in America due to his anti-gun political stance. When a Democrat controls the office, the threat of gun control propels consumers to buy more firearms/ammunition. Consumer demand for firearms and ammunitions increased significantly due to the perception that Hilary was going to win the 2016 election, but when Trump ultimately took office, fears of gun control dissipated and demand for firearms sharply declined. Distributors and consumers had excess supply of inventory and competitors were heavily discounting products through rebates in order to keep up manufacturing capacity; VSTO had to match the discounts to defend market share. Commodity input costs (copper, lead and zinc) were on the rise which put further pressure on margins.

Investment Rationale

Thesis 1: Sales decline and depressed margins for the Shooting Sports segment should be temporary for the following reasons:

• Demand has not disappeared and was merely pulled forward. Ammunition is a consumable and must be replenished after use. Management estimates that the ratio of ammo consumed at shooting ranges vs outdoor hunting is 4:1 (11/17/16 Investor Day). This implies that although hunting is a category that is not exhibiting growth, and may even be in a state of decline, it is only a small fraction of total ammo consumption.

• Proliferation of gun ranges, female shooters and high school trap shooting. Females and millennials at the gun range as well as high schoolers competing in trap shooting competition create new sources of demand for ammunition. Talking to a couple of gun range owners, they have seen growth in firearm training classes as well, mainly for self-protection reasons.

• Distributor inventories have normalized (confirmed by management and several distributors), so sell-throughs will be more in line with sell-ins. Discounting environment have normalized as well.

• NICS background checks (a proxy for guns sales) have stabilized

NICS Image created by author using data from NICS Firearm Background Checks

• Commodity cost pressures have abated. This could potentially cause upside in the near term for margins as management baked into its FY 2019 forecast that peak commodity prices back in 4Q18 would continue and the inflation would not be 100% passed onto the consumer.

Commodity Prices

Business Insider

• Last year was a very difficult environment to raise prices in order to combat cost inflation due to the excess supply and inventory in the market. The current supply and demand conditions are much more favorable for passing on costs.

• R&D expense have increased to align with industry standards. Potential for product development and differentiation. VSTO’s CAGR for patents and product development professionals are in the low teens for 2015-2018, greatly outpacing sales CAGR of 3.5% over the same time period.

• From a political standpoint, it can’t get worse for firearms and ammunition sales. If the next president is a Democrat, then there will likely be more fear buying. If the next president is a Republican, then the current market conditions will persist.

Thesis 2: Heavy insider buying in the $13-$15 range.

Thesis 3: VSTO is rapidly de-levering by selling assets in Outdoor Products and its firearm business (I estimate after tax proceeds to be ~400M, which should reduce current debt by ~40%). The company issued too much debt and grew too quickly during Obama’s presidency. New management should have learned from past management’s mistakes and will favor smaller bolt on acquisitions in place of larger acquisitions fueled by excessive debt.

Thesis 4: Gun accessory sales should rebound. 25% of the Outdoor Product segment’s sales are tied to firearm accessories. The historical consumption pattern has been: buy a gun, save money, then buy some accessories for the gun. For the last couple of years, until Trump got elected, consumers would just buy a gun, save up, then buy another gun; accessories were largely neglected. This pattern should change as purchases will no longer be driven by fear.

Thesis 5: The health of the retail channel should be a lot better in fiscal 19 vs fiscal 18 due to the lapping of Gander Mountain’s bankruptcy on March 10, 2017. When a distributor goes bankrupt, its competitors usually will have temporarily depressed sell-throughs because of the liquidation process. Both Gander and its competitors would have ordered fewer products from VSTO, but this is just a timing issue and does not impact end demand of the consumer. This also applies to distributors like REI which have chosen to not sell firearm products (for ethical reasons). The end demand doesn’t disappear as people will just find another retailer to purchase desired products.

Model Inputs and Valuation

I’m modeling from my FY 2020 projections. The rebound could potentially be later given a prolonged ammunition cycle. Management already gave 2019 guidance, I think it was low-balled and does not account for favorable commodity costs. This company is not cheap on 2019 guidance, currently ~11.5x EV/EBITDA. Some of this rebound is probably already priced in.

Asset sales should decrease FY 2018 revenue by ~600M. I’m assuming ammo sales rebound and Shooting Sports revenue should increase by 10% from 2018 after selling off firearm brands. I’m projecting a modest 5% sales rebound in Outdoor Products, after accounting for asset sales, due to the lapping of Gander’s bankruptcy and normalization of consumption behavior of accessories. This translates to sales of $752M for Outdoor Products and $1,090M for Shooting Sports. Margins are pretty much in line with historical, obviously a pretty big bounce back from 2018 trough.

I project ~400M after tax proceeds from asset sales.

Asset Sales

All proceeds will be used to pay down debt. And I’ve modeled interest expense as though equal proportions of term loan and senior notes will be paid off. Tax rate is 30%. Diluted shares will increase to 58M. I doubt there will have much capital leftover to buy back shares. Management is projecting $55-$85M of free cash flow for FY 2019, which I have not included in the equity value calculation. Maintenance capex is modeled at 2.5% of revenue.

I use 8.5x EV/EBITDA (consistent with 2 year historical), 15x P/E (one whole turn less than RGR and AOBC), and 12x FCF (pretty much a rule of thumb). Based on these valuation multiples, I think VSTO is worth around $23. ~40% expected return for a 2-3 year holding period.

Valuation + Model

Disclosure: I am/we are long VSTO.