Description

Brass Eagle (XTRM) is a dominant company in a growing niche, trading at 5 times fully taxed 2002 projected EPS (based on management’s recent public projections) and at about 3 times what we believe normal EPS to be (based on management’s projections for 2001 before the economy turned bad). At a reasonable multiple of 15 times normal earnings of $1.50, we think the stock should be in the $20-25 range within a couple of years, versus under $5 today. So from a reward standpoint, this is a potential 5-bagger within 2 years. From a risk standpoint, downside should be limited given the company’s strong market position, continued profitability and debt of less than 2x EBITA.

XTRM is the leading manufacturer of paintball equipment, including markers (guns), paintballs, and accessories (safety equipment, cleaning supplies, paintball hoppers, etc.). XTRM is actually a spin-off of the old Daisy Manufacturing air-gun business. Products are sold under the Brass Eagle, Viewloader, and JT USA brand names. Their niche in the paintball industry is really a focus on the lower end of the market (mostly entry-level players), with most sales through mass merchandisers. They’ve recently also been expanding into the recreational and competition level markets, which is the higher end of the market. They believe that they are the only manufacturer in the industry with a full line of products that address step-by-step price points for beginner, recreational, and competition level paintball participants. XTRM owns the category for entry-level players, and part of the strategy going forward is to bulk up their offerings in the higher end areas of the market, so that they can keep the entry-level players as they advance. About 85% of sales are to national and regional mass merchandisers, such as Wal-Mart and K-Mart, and major sporting goods retailers, such as The Sports Authority and Dick’s Clothing and Sports. The remaining roughly 15% of sales are to sporting goods distributors, specialty distributors of paintball products, and paintball specialty shops. Wal-Mart is their biggest customer – in 2001, Wal-Mart was 53% of sales, and in 2001, K-Mart was 8% of sales.

XTRM’s sales to Wal-Mart and K-Mart are linked to XTRM’s ownership of the lower end of the paintball market – by getting these big mass merchandisers to carry XTRM’s paintball products, the paintball market got exposed to the masses. As paintball grew from being a sport practiced by avid enthusiasts using high-end, expensive gear, to a more mainstream recreational pursuit practiced by corporate groups, church groups, youth leagues, etc., XTRM has been there at Wal-Mart ready to outfit the lower end players who have been the drivers of growth in paintball. You can go into a Wal-Mart and see that XTRM dominates their paintball offerings – you’ll see that almost all paintball products are Brass Eagle’s, with maybe one or two competitive offerings, none of which are focused on XTRM’s entry-level customer. Over the last few years the company has done a few acquisitions – the most significant was the acquisition of JT USA in 2000, a higher end manufacturer which gave XTRM the industry’s premier brand name in protective gear.

The paintball market is estimated by the company to be $430 mm in 2001, which includes equipment, paintballs, and playing field fees. In 2001, XTRM did $92 mm of revenues, so they have about 21% of the total paintball market. Aside from XTRM’s sales through Wal-Mart, K-Mart, and the big sporting goods retailers, most other paintball business takes place through mom and pop type specialty shops. Given its history as kind of an underground activity, it’s difficult to come by solid data on the size and growth of the industry (we’ve tried). The company believes that underlying growth in the industry continues to be 10%+ per year. According to Paintball 2Xtremes Magazine’s January 2001 issue, paintball is the 4th largest alternative sport in the US. More than 5.9 mm people played at least once in 1999, and about 800,000 people play at least 15 times per year. This article also says that in the US at the time there were 16 paintball related magazines, about 1160 paintball stores, about 950 paintball fields, and about 1827 paintball related web-sites.

The company’s strategy is to continue to grow with the overall paintball market, launch new products to go after the higher ends of the market (JT USA gives them a brand name to do this with), and increase distribution in specialty channels (which is where the high end of the market is). Longer term, they think there is the opportunity to grow into other extreme sports – the concept is that XTRM has the relationships with large retailers and they know how to market to the demographic groups attracted to extreme sports. This strategy appears to make sense.

XTRM’s revenues have grown from $36 mm in 1997, to $75 mm in 1998, to $68 mm in 1999, to $87 mm in 2000, to $92 mm in 2001. Reported fully taxed EPS was $1.07 in 1998, $1.07 in 1999 (even though sales declined, they improved margins plus had a lower tax rate), and $1.20 in 2000 (the $1.20 excludes $0.05 of special charges associated with evaluating a buy-out offer). From 1997 through 2000, they had grown revenues nicely and increased EBITA margins each year – starting at 17.3% in 1997, increasing to 19.5% in 2000. In February 2001, management projected revenues of $103 mm to $110 mm for 2001, and EPS of $1.35 to $1.40 for 2001 – note that this includes goodwill amortization of about $0.20 – so in February 2001, management was projecting $1.55 to $1.60 of cash EPS, which would have been an EBITA margin of about 20% based on $105 mm of sales.

All of that sounds great, and the stock reached a peak of around $25 in mid-1999. But along the way they have had two hiccups, which together appear to have created today’s opportunity. The first one occurred in 1999, when sales growth began slowing, and the company actually had negative growth for the year. In the last three quarters of 1999 and first couple quarters of 2000, quarterly revenues were down year over year. Prior to this, XTRM was trading as a high growth company at a growth multiple, and when growth apparently stalled, the stock got killed. During 2000 the stock was as low as $3. Initially revenues were down due to merchandising and planning problems at K-Mart, and in the last couple of quarters of 2000 revenues were hurt by an inventory adjustment at Wal-Mart. In the first part of 2001, revenues were hurt by retailers delaying orders for old products in anticipation of a new product roll-out. However during this time the company continued to report good earnings, with $1.07 in 1999 and $1.20 in 2000. Starting in mid-2000, the business improved again, due to the completion of Wal-Mart’s inventory adjustment and the acquisition of JT USA.

By mid-2001, the market was starting to regain confidence in the company and the stock climbed to around $10 – still cheap at only 6 times earnings projected for 2001. However, the second hiccup happened in mid-2001, when management lowered guidance due to slower than expected sales based on retailers’ conservative business outlook and inventory management, due to the economy. In August of 2001 management lowered 2001 guidance to $100 mm to $105 mm in sales and $1.00 of EPS ($1.20 cash EPS). This news caused the stock to begin a descent towards $5 over the next few months. In October of 2001, they pre-announced that 9/11 and the resulting slowdown in consumer purchases (and impact on retailers’ willingness to hold inventory) had further impacted their business plan – lowering expecting 2001 sales to $85-$95 mm and EPS to $0.60-$0.85 ($0.80-$1.05 cash EPS). When Q4 2001 was reported in February 2002, the company ended up with $92 mm in revenues and $0.61 in EPS (excluding a $0.09 charge related to K-Mart bankruptcy), which is cash EPS of about $0.81 per share for the year.

With their 2001 full year earnings release in early 2002, the company projected that in 2002, they would do $96 mm to $100 mm in sales and $0.85 to $0.95 of cash EPS (no more goodwill amortization under new accounting rules). Note that on $98 mm of sales in 2002, this implies EBITA margins of only 13.1%, up from 12.3% in 2001, but well short of their 1997-2000 average margin of around 18.5%. The company’s 2002 projections are based on the retail environment continuing to be challenging, resulting in the company being “cautiously optimistic” for the coming year. In the earnings conference call, they discuss how in Q4, consumer demand and sell-through was actually pretty strong, but retailers and Brass Eagle were being very cautious on inventories. As a result of their conservative planning, Brass Eagle couldn’t supply retailers with enough product to meet demand in Q4. They believe that retailers currently have very low levels of inventory, but don’t seem to be in a hurry to increase inventory levels – retailers are continuing to be cautious in buying. Expectations for 2002 are based on the first half of the year being relatively weak due to the economy and retailer cautiousness, and the second half picking up. There is some normal seasonality in the business, with the second half and Q4 in particular being stronger due to the holiday season.

Market capitalization consists of 7.5 mm diluted shares * $4.60 stock price = $35 mm market cap. At 12/31/01 they had $25 mm of debt – consisting of $3.9 mm on revolver and $21 mm in terms loans (used to finance JT USA acquisition in 2000, amortizing at $6.4 mm per year). (Other balance sheet items look okay – receivables of $26 mm is about 2 months worth, inventories of $13 mm is about 2-3 months worth, and payables are pretty low). So that is an enterprise value of $60 mm. In 2001, the company did EBITA of about $11.6mm (excluding the K-Mart receivable write-off). So the company is trading at about 5.2 times the depressed 2001 EBITA. In 2000, the company did EBITA of about $17mm; so the company is trading at about 3.5 times 2000 EBITA. (Note that we are using EBITA, not EBITDA; we detest the whole EBITDA notion since it generally represents nothing realistic.) The $0.90 of EPS they are projecting for 2002 implies about $13.0 mm EBITA, putting the company currently at 4.6 times this year’s low EBITA.

Looking out a couple of years, we have no reason to believe they can’t return to average EBITA margins of say 18.5% on a moderately growing sales base. Say that in 2004 they have sales of $115mm, and margins of 18.5%, that would produce EBITA of $21mm. Between now and then, they would have paid debt down by roughly another $17mm, so that there would then be only $8mm of remaining debt, and fully taxed EPS would be running around $1.50. And this would be no better than the pace they were talking about doing for 2001 before business turned down, so management probably has higher aspirations for 2004 than $1.50 EPS. But to continue, if at that point, the company is worth 8X EBITA (remember that’s EBITA, not EBITDA) – that’s $168 mm, less $8 mm in debt, leaving $160 mm in equity, over 7.5 mm diluted shares, or $21-22 per share. That would translate to a 14 PE on $1.50 of earnings.

Besides the likelihood that the stock should trade up to a fair PE on its own, the other catalyst for value realization is the fact that it is 50% owned by a buyout firm “Charter Oak Partners”, who will eventually be looking for an exit (www.charteroakpartners.com). XTRM would make a nice acquisition for a manufacturer looking to grow into the extreme sports segment.

What are our concerns? Management and Charter Oak are very non-promotional and it’s tough to get them to talk about the business; there’s not much we can do about that but hopefully in the long run that’s immaterial….. Also the paintball industry is not very well researched and documented. Besides reviewing XTRM’s info and industry publications (which are mostly aimed at players not investors), we have thus far addressed that by interviewing a sample of about 25 paintball distributors, specialty shops, field operators, and sporting goods department managers at individual Wal-Mart and K-Mart stores, and we have received generally positive feedback about Brass Eagle’s products and market position, overall consumer demand and interest in paintball, etc. (We didn’t have any luck in getting either the Wal-Mart or K-Mart sporting goods buyers to talk to us.)…..Another issue is that the float is not very significant – Charter Oak Partners, plus directors and management together own about 65%. As a result liquidity is relatively low, with only about 15,000 shares traded daily (although volume was higher when the stock was “hotter” in 1998-1999, and likely should again pick up meaningfully as the price picks up again)……Another issue we can’t pin down with certainty is whether margins will return to the 1997-2000 level as sales continue increasing. It is bothersome that Wal-Mart is over 50% of sales, but Wal-Mart has been a key part of XTRM’s growth – Wal-Mart was a 28% customer in 1997 based on $37 mm of sales, but grew to a 63% customer in 1998 on $75 mm of sales. While the Wal-Mart business is pretty mature at this point, XTRM seems to be delivering for WMT and likely has competitive advantages over any other potential competitor given its dominance of the sector. In any event, the stock still has a lot of upside potential even if one assumes that margins do not return to 1997-2000 levels.

In conclusion, XTRM seems to be a very compelling idea. It’s a company with a dominant position in a growing market, with “lumpy” but good sales and earnings trends over time (isn’t it Buffett who said give me a lumpy 18% over a steady 12%, or something like that?). It has overcome several setbacks, and beautifully, it still made good money during such difficult periods and then resumed its progress – which indicates either good management or a good competitive position. XTRM is trading at about 5 times this year’s subdued earnings and about 3 times what we think earnings should be in a more normal economic environment (and what management was projecting the company to do originally in 2001). There are opportunities for growth both internally as the industry grows, and through acquisitions in other paintball market segments and other extreme sports fields. The company is generating cash and will be creating value by paying down its modest debt over the next several years. There is a sophisticated shareholder holding about 50% of the stock, who will eventually want liquidity, which will likely take the form of a transaction of some type. For the above reasons, we conclude that XTRM is trading at a ridiculously low price, and we think a $20-25 price target in a couple of years is certainly attainable.

Catalyst

Very cheap versus current low EPS rate and even cheaper versus more normal earnings rates. Dominant company in a growing niche.