Description

Clarus reports earnings later today. We are either going to look very dumb (stock rips or is flat) or really smart (big miss). That’s not important. This is ultimately a multi-quarter thesis. Regardless of what happens today, we think this is a compelling short.

The bull thesis for Clarus is that this is a roll-up with platform value focused on acquiring under-monetized brands that have loyal followings. Bulls claim the platform value comes from enacting an “Innovate and Create” playbook of product/distribution expansion.

While this may be true to a certain extent, we think the market is ascribing a full roll-up platform value multiple to medium term peak earnings that will shortly be cut in half. We think Clarus has benefited significantly from supply/demand tightness in the commodity and hunting ammo markets due to one-off factors. Our differentiated dataset and research suggest 1) ammo imports are rising, 2) domestic capacity is increasing, and 3) demand is rolling over, 4) ammo pricing has already declined YoY over the last 6 months and has accelerated in July. Retailers will be awash in inventory over the next few quarters and manufacturers like Clarus will see demand drop just as industry supply additions kick in. Earnings should revert to slightly above 2019 levels. Downside is 40-50% from here.

 1.       Quick business overview:

Clarus has three segments.

·         Outdoor: sells outdoor equipment in segments like Mountain, Climb, Ski under the Black Diamond, PIEPs, and SKINourishment brands

·         Precision: manufactures and sells bullets/ammo for precision shooting, hunting, defense, and military uses under the Barnes Bullets and Sierra brands

·         Adventure: offers engineered automotive roof racks and mounting systems under the Rhino-Rack and MAXTRAX brands

The company mainly sells to sporting goods and specialty retailers. A small portion of sales goes through DTC.

2.       Financials:

In 2019, Clarus earned 15.6m from the Outdoor segment and 4m EBIT in the Precision Sport segment for a total segment EBIT of 19.6m.

In 2021, Clarus earned 16.2m, 34.2m, and -2.2m from the Outdoor, Precision, and Adventure segments.

Between 2019 and 2021, the company acquired a few businesses that created the Adventure segment and acquired Barnes Bullets for the Precision Sport segment. Barnes was run-rating ~half the size of Sierra at acquisition. For the sake of simplicity, let’s assume Precision Sport pre-COVID EBIT was 7m (3m incremental from Barnes including synergies) vs. pre acquisition of 4m. Thus, Precision Sport EBIT increased 5x from 7m to 34m from 2019 pre-COVID to 2021. Margins expanded from mid-teens % in 2019 to 36% in the latest quarter.

The ammunition/bullet segment is now 70% of segment EBIT and is over-earning. This is where we focus the write-up.

3.       What caused the ammo shortage?

As mentioned by zipper in the VSTO write-up, firearms/ammo have seen significant shortages during the pandemic. This is due to demand growth significantly outpacing supply growth.

·         Supply

o   Imports:

§  Supply chain disruptions: imported ammo since the start of the pandemic has experienced delays of between 6-12 months

§  COVID-19 shutdowns in Europe affected manufacturers in Spain, Italy and Eastern Europe

§  On the margin, restriction of imports from Russia. While there have been estimates that 20-30% of US ammo is from Russia, this was not substantiated in our diligence. Furthermore, our price tracker for ammo (below) did not show any substantial ammo price increase leading up to (e.g. stockpiling) or after (e.g. shortage) the ban was enacted in 9/2021.

o   Labor shortage

§  Given stay-at-home, infection of workers, general labor shortage, manufacturers could not hire, train, retain workers at a pace that matched the demand growth

o   Remington bankruptcy took capacity out of the market. Customers bought from other manufacturers who couldn’t ramp up capacity right away. VSTO brought the capacity back online in 2021.

·         Demand

o   Consumer psychology: The combination of riots, election, COVID drove buying from consumers who wanted a sense of security

o   Social distancing and fear of virus drove bump in solitary recreational activities like hunting/shooting

4.       Differentiated dataset suggests increased imports are loosening the supply/demand balance:

From our industry checks, primers were the main components in shortage. As a refresher, this is the anatomy of an ammo. 

While supply is not coming from the for-sure-fake expansion announcement by Expansion Industries for a new Texas primer plant, imports of primers/ammunition have increased. In the past, there have been four main domestic players of primers: Federal, CCI, Remington, and Winchester. In the last few years given the primer shortage, shipments from international suppliers including Armscor, Sellier & Bellot, Fiocchi have increased.

The increase in imports (despite continued tight shipping capacity) more than offsets the Russia imports lost to the import ban. Russian ammunition/primer producer Murom Apparatus has been cited in the industry as a significant player. It imported about 180k kg of “stuff” in 2021. That slowed in late 2021 and completely stopped as of mid-March 2022.

In 2021, non-Russia players imported significantly more. Fiocchi imported 14m kg, Armscor 7m kg, and Sellier & Bellot imported 6m kg.

In the first 6 months of 2022, they collectively increased imports by 32% YoY. Sellier had its biggest import volumes ever in the last few years in April and June with 1m kg (up 2.7x YoY) and 3m kg (up 9x YoY) of imports, respectively. Imports have not slowed down YoY since the start of the Ukraine war. 

As shipping capacity continues to increase, the onslaught of imports will only increase and exacerbate the oversupply of ammunition in the US.

While consumers do have preferences for domestic brands, our research suggests a price discount of 15-20% is enough to incentive consumers to switch in normal economic times. Given inflation, the discount is likely less. Thus, as raw material prices decline, importers can cut ammo price to gain share. Domestic players will have no choice but to respond.

There are other ways we gain conviction that the primer shortage is already alleviating, partially caused by the influx of imports. Four months ago, our checks offline and online suggested there was still shortage. Now, primers are more available for sale online and in the channel. In periods of tightness, ammunition manufacturers prioritize primer inventory for loaded ammo (better margins, higher ASP). In times of excess supply, manufacturers add standalone sales to keep plant utilization high. The fact that primers are more available online and in the channel is telling.

5.       Domestic supply additions are coming:

Current ammo/bullet industry supply pictures from our diligence and estimates.

·         Ammo: 400m rounds

·         Remington: 350-400m rounds

·         CCI: 350-400m rounds

·         Federal: 350-400m rounds

·         Sierra: 320m rounds

·         Barnes. 40-50m rounds

·         Winchester: n/a

Ammo had 50k sq of manufacturing facilities. They are adding 160k more. Full production capacity will be 1bn rounds. They’re targeting production soon. This increases industry domestic capacity by about 15-20% (wide range given no data on Winchester capacity).

Clarus bought the surrounding land around Barnes’ HQ in order to facilitate capacity expansion.

Hornady is expanding one plant by 20%.

Firearm capacity can be added in small increments given the use of CNC machines. Bullet/ammo/primer capacity requires large machines and thus the ramp in capacity can take anywhere from 6-18 months. Thus, non-firearm capacity ramps in step functions. It’s likely that the step function capacity increases will arrive just as demand undershoots significantly.

6.       Demand is weakening:

Implied demand is already weakening. Store checks now show more available inventory. Yes, this is anecdotal. Commodity firing range round inventory levels are building according to industry experts. Demand to sales ratios have also declined significantly vs. early last year.

7.       Differentiated dataset on ammo pricing suggest prices are collapsing:

Bullet/ammo pricing increased during the pandemic as 1) raw materials like lead and copper increased during the pandemic given shortages and competition from other sources of demand like EV batteries and 2) tight market conditions enabled pricing increases in excess of raw material cost increases. That should reverse.

According to our dataset, industry ammo prices are already falling. Price declines have gotten worse Q3TD. 

8.       Other segments:

There is not much point discussing the other segments. After the greatest outdoor apparel/goods tailwind during COVID, the outdoor segment only generated $16m of EBIT, a 4% increase from 2019. Any “Innovate and Create” initiatives will be vastly overshadowed by the reversion of Sierra/Barnes to normalized earnings.

9.       Valuation:

·         VSTO trades at 3x consensus EBITDA and 10x normalized EBITDA. We think it is still a short (~20-30% downside).

·         Clarus trades at 11x consensus EBITDA, 18x normalized EBITDA, 38x normalized EPS. We think downside is 40-50%.

Our normalized margin assumptions are as follows:

Outdoor EBIT: 12m

Precision sport EBIT: 20m

Adventure EBIT: 10m

Corporate EBIT: -12m

Total EBIT: 30m

Normalized EPS: ~$0.55

Price target is ~$10-11, ~50% downside.

10.       Risks:

VSTO’s acquisition of Remington results in a more disciplined oligopoly in this cycle

Fall hunting season is strong, which delays the ammo downturn

Catalyst

Precision segment margin and revenue decline in the subsequent earnings prints