Description

Coastcast is an investment based on either a sale of the company or the reinstatement of a substantial dividend in the next year. The stock has been punished due to a combination of poor operating results, which have already improved, and tax loss selling. The reasons to buy Coastcast today are that at current levels, the stock is extraordinarily inexpensive and there are several near term catalysts that should drive this stock higher.

Coastcast is the largest domestic supplier of golf club heads. Its largest customers are Callaway and Taylor Made, accounting for 76% of sales in 2000. The company also manufactures orthopedic implants, automotive products and other specialty products. These sales are tiny compared with Golf, but could be a source of future revenue and profitability.

From 1997-2000, Revenue oscillated between $120mm-$150mm and EBITDA ranged between $15-20mm. Beginning in fourth quarter of 2000, Coastcast’s operations deteriorated as the company was unable to manufacture the new Calloway club head without large amount of rejects. These manufacturing issues caused a corresponding drop in sales as Callaway went to other vendors. The high level of defects caused large amounts of scrap metal, which dug into gross profit due to the high cost of titanium. In addition, the company also lost some steel club business to lower cost Asian competition. These problems caused a drop in LTM sales to $115mm from $141mm at year-end 2000. EBITDA went from $16.40mm to $3.70mm. The company has turned the corner as of Q3, comparable sales, gross margin, and EBITDA are essentially flat year over year due to solving of production problems.

Valuation

Until 2001, I would have pegged Coastcast’s normalized EBITDA in the mid to high teens. Now, I shall use LTM numbers for trough earning power. I will use $20mm as a peak EBITDA number and average operating statistics off the two numbers to get a normalized earning power:

LTM Peak Normal
EBITDA 3.67 20.0 11.84
DA 4.66 4.66 4.66
EBIT (0.99) 15.34 7.17
Interest 0.37 0.37 0.37
EBT (0.59) 15.74 7.57
Taxes 0.26 6.36 3.05
NI (0.36) 9.37 4.49
EPS (0.05) 1.22 0.59
Maint. CapX 3.00 3.00 3.00
EV/EBITDA 7.04 1.29 2.18
EV/EBIT NA 1.69 3.64
P/E NA 3.74 7.82
EV/EBITDA-CapX 38.94 1.52 2.93


Coastcast's business is very labor (3,828 employees) and material intensive (titanium is expensive), but not very capital intensive ($3mm in maintenance CapX). EV/Book Value is 0.69 and book is mostly cash ($1.21 per share), PPE and working capital. In other words, it is tangible. While the company’s margins are relatively lean, it does generate a large amount of free cash flow on limited capital employed (about $10mm of normalized free cash flow on $40mm of capital). The industry is projected to grow in one McKinsey report by 2-3% for the next 10 years. Coastcast is one of 2-3 domestic suppliers capable of casting the high-end clubs in large quantities. Domestic suppliers are preferred to foreign ones for the high-end clubs due to counterfeiting.

Coastcast also trades on it lows because it is a micro cap stock that gives minimum disclosure about its operations. By talking with the company and with the venture backer of their largest competitor, I determined that the recent operating problems were company specific (i.e. you can fix the company but not the industry. Since the bulk of profits are made on the titanium side, the drop in steel club revenue is not as important as the surge in COGS due to production snafus with the titanium clubs). An interview with the company's sales manager also revealed that production is now running smoothly and that orders are picking up. It is also worth noting that even during the dismal second quarter, Coastcast was still able to generate a small amount of cash.

Last year in response to dissident shareholders, the company paid a $5 special dividend and initiated a $0.26 regular dividend. Many holders bought the stock as a dividend yield play (the company had been generating the cash to support such a payout). When operations went south, the dividend was suspended after one payment – leaving many holders with a high tax basis stock from the per $5 dividend period (mid teens dollar price) and angry about the change in results. These holders have a strong incentive to sell by year-end.

Catalyst

1) Tax Loss Selling Ends.

The stock has been under heavy selling pressure by two large holders, one of whom I recently cleaned up. I believe that the end of tax loss selling alone could make the stock appreciate over $2 – bringing it closer to book value.

2) Dividend Yield.

The company suspended its dividend in the face of operating difficulties but promises to reinstate it as cash flow returns. If the company were to pay the $0.26 quarterly dividends that it started to pay, it would distribute $1.04 per year. At current levels, that represents a 22.6% dividend yield - a great return if the stock never appreciates. If the stock were to trade at a 10.0% dividend yield (valid given the lumpy dividend and earnings), it would trade at $10.60 (6x normalized EBITDA) - A home run. A 5% yield equals $21.20 per share (4.6x your money, 13x normalized EBITDA/7.8x peak). The company has several large activist holders, including Bedford Oak Partners, who are looking to get that yield or sell the company should things not turn around.

3) Sale of the Company

Last year the company had a failed auction led by Bear Stearns. The company rejected a bid of about $20. $20 less the $5 special dividend is still a takeout value of $15 per share or almost double current levels. Now that bid was in a better economy with better financing markets and before operations deteriorated. However, a bid of 6x normalized EBITDA or $10.60 would not be out of the question. Hans is 68 years old and an excellent operator. However, recent health problems have made him more receptive to a total sale of the company than he was during the Bear Stearns process, which was forced on him by the dissident shareholders. I would not be surprised to see a new sale process begin after a couple more solid quarters.

In short, Coastcast is a company where management is committed to paying out a substantial amount of free cash flow back to shareholders (assuming the operations are fixed and dividend rate is kept up), trading well below book value, and only 2x normalized EBITDA with large activist shareholders looking out for your interests and the chance for a takeover. The stock has lots of upside, and not much downside.