Description

FOX Factory (FOXF) is a manufacturer of high-end shocks for mountain bikes and powersport vehicles. The vast majority of Fox’s growth over the past several years, however, has been driven by an expansion into auto products such that auto now represent over 50% of sales. Fox doubled down on its auto exposure when it announced a high priced deal to acquire SCA Performance right before the current crisis started. This deal added leverage and even greater cyclical risk at exactly the wrong time. Prior to the possibility of a recession, Fox was likely to see a significant deceleration in growth. That was in combination with questionable earnings quality, management departures and heavy insider selling. Amidst the current environment, Fox could see a dramatic (auto supplier-like) reduction in earnings, raising the possibility of a covenant breach and material downside to already lowered numbers. The extent of this risk does not seem to be fully anticipated by the Street - maybe this is because the stock is covered by consumer analysts as opposed to auto folks. With the stock rallying 45% off its recent lows, FOXF is now down only 17% from when it reported Q4 earnings. This appears to be an attractive entry point with potential downside of $20 (60% below current levels).

For further background, I would refer you to maggie1002’s write-up from 2007. This does a great job detailing some of the history. What you need to know is that Fox operates in two segments: Speciality Sports Group (“SSG”) and Powered Vehicles Group (“PVG”). When FOXF came public in 2013, SSG was the majority of the business at ~70% of sales. This segment is Fox’s legacy - selling high-end shocks to mountain bike enthusiasts and extreme sports aficionados. As a result, the bicycle manufacturer Giant was Fox’s largest customer for a long time before recently falling off. SSG is a nice, niche business where Fox has a very strong brand though there’s relatively unexciting growth.

PVG has become the main attraction over the past several years and now accounts for 60% of sales. The original idea was that PVG was selling Fox shocks to the likes of Polaris and BRP to put on side by sides, snowmobiles, etc. However, around 2016 Fox began to see real growth in its auto business as off-road capable trucks became more and more popular. A key win to supply Fox-branded shocks to the Ford Raptor turned into other wins on similar nameplates (Ford Ranger Raptor, Toyota Tacoma / Tundra / 4Runner / Sequoia TRD and, most recently, Jeep Gladiator Rubicon). These OE wins then led to aftermarket business, which was supplemented by acquisitions. At Q2’19, management (for the first time ever) revealed that auto products accounted for ~50% of sales, implying that auto was ~80% of PVG (the main growth driver). 

Fittingly, the recent 10K revealed that Ford is now the largest customer at 11% of sales. FY19 revenue attributable to Ford spiked 67%. Meanwhile, Giant (which was a 17% customer as recently as FY16) no longer makes the cut. 

Prior to the current economic concerns, the idea with Fox was that its outsized growth was entirely driven by PVG, which was in turn entirely driven by auto and there was reason to believe that auto would soon moderate. To put this growth into perspective, Fox has reported revenue growth of >19% in each of the past eight quarters. It has been a clear beat and raise story. However, digging a little deeper shows that PVG, and more specifically auto, has been accounting for over 80% of the dollar revenue growth (note that PVG sales growth clocked in at over 30% in seven of those same eight quarters). 

The problem with auto is that a significant portion of Fox’s growth in FY18 and FY19 appears to have come from new OE nameplate wins that are unlikely to repeat in FY20. Fox entered FY18 with two nameplates and exited FY19 with seven. While there has been chatter of other potential wins, these seem to be less significant and more likely to occur in FY21 or later. In addition, Fox’s most important nameplate (the Ford Raptor) was planning to go through a changeover in 2020 and IHS forecasted Raptor units down pretty significantly in Q2’20 onward. As such, it seemed possible that Fox’s auto OE business might actually decline.

These fundamental concerns around the auto business were paired with a number of red flags. Almost every key executive has left the business over the past year, including the CEO, CFO, CTO and CMO. This was accompanied by heavy insider selling. The former CFO, for example, sold 80% of his stock from June through his last reported filing in September. Meanwhile, the new CEO, Mike Dennison, has a checkered operating record from his time at FLEX. 

If that wasn’t enough, Fox also has questionable earnings quality. This includes low depreciation (suggestive of extended useful lives), capitalized expenses and unusual tax rate gains from favorable SBC and IP classifications. As a result, FCF/share has been well below “adjusted” earnings. For FY19, adjusted EPS of $2.71 compared to FCF/share of $0.54. These accounting games appeared to be running thin as earnings beats in 2H’19 were increasingly lower quality, often relying on greater add backs and surprise tax rate variances.  

Then, in early February, the plot thickened. This was when Fox announced that it was acquiring a business called SCA performance to further expand its auto aftermarket presence. SCA is a specialty vehicle manufacturer. What does that mean? As another VIC member aptly put it, they “pimp out pickup trucks.” Its instagram feed will tell you all you need to know: https://www.instagram.com/sca_performance/?hl=en. 

Beyond being Fox’s largest ever acquisition, there were a lot of things that were odd about the SCA deal. For starters, the valuation was a real head scratcher. Fox paid 3.6x revs and 14x EBITDA with minimal expected synergies. Tusancy, a largely identical business, was acquired by Fox in FY18 for 1.6x revs. In fact, every acquisition Fox has ever made going back to FY14 has been between 1.0-1.6x revs. But not only was it a high price, it was also right before earnings. Fox announced the deal on 2/12 with Q4 earnings and initial FY20 guidance slated for 3/3. Not surprisingly, the SCA deal was expected to close near the end of Q1, right before Ford Raptor sales were likely to start declining. 

Maybe more importantly though, the SCA deal saddled Fox with leverage and introduced even more cyclicality. Management said that they expected leverage to rise to 2.5x at deal close (and this was assuming a pretty rosy economic backdrop). Mind you, Fox was a business that was historically close to debt free. Pro forma for SCA, the auto products business is now ~55-60% of sales. For obvious reasons, selling a “black widow” pickup truck for $70k could be a tough business during a recession.  

https://www.scaperformance.com/chevy-black-widow       

https://www.motor1.com/news/367210/chevy-silverado-spider-makeover/ 

The earnings report on 3/3 should have validated these concerns. Fox’s FY20 sales guidance (ex-SCA) implied YoY growth of just 8% (and closer to 5% in the 2H). This compared to organic sales growth of ~20% in each of the past three years. In addition, the EBITDA guide implied organic growth of just 7% (and 3% at the lower-end of the range). Bear in mind that Fox had grown EBITDA 32% in FY17, 33% in FY18 and 17% in FY19. Moreover, it had a valuation to match these growth rates, trading at >20x EBITDA for most of the year. It should have been clear from the earnings report that growth was dramatically slowing and that SCA was an expensive, last minute deal to avoid a horrific guide. Apparently that wasn’t clear as the stock traded up 7%.

Fast forward to today. A lot has changed in the past month. To the extent that we head into a recession, Fox’s business will be in the crosshairs. The PVG segment (65% of sales) is likely to act like an auto supplier. In recession scenarios, it’s not uncommon to see auto suppliers with EBIT declines of 40% or more. Fox’s auto business could conceivably do a lot worse given that a good chunk of its recent OE growth was from new nameplate wins and its aftermarket business is essentially selling high priced toys. The traditional mountain bike business (SSG segment) is less susceptible but even this business declined 13% in FY09. 

Putting that all together suggests that Fox could see a sales decline of ~30% and I suspect that would translate to a 35-40% hit to EBITDA. Inclusive of SCA, that would get you to EBITDA of ~$100m or $95m ex-SBC (Street is at $135m). With the EV at $2.4b, Fox is currently trading at 23-25x those numbers. Where could this go? With the exception of FY19, Fox has traded at 9-11x EBITDA on its annual lows every year since coming public. Using those same multiples would suggest a downside price of $15 to $20 - a long way from the current price of $50.

It’s also worth noting that if EBITDA falls below ~$120m, Fox will breach its consolidated leverage covenant, which stands at 3.75x. The numbers quoted above would imply leverage closer to 4x. Like many other businesses, I assume that Fox will be able to get an amendment; however, maybe more importantly, I’m not sure that most investors even realize that Fox has any debt. Since the SCA deal isn’t set to close until Q1, Bloomberg currently shows Fox being close to net cash. This could be a rude awakening if results sour.

Given all of the above, it shouldn’t be that surprising that Fox pulled its guidance after the close on Thursday and pointed to Q1 sales and earnings at the low-end of its prior outlook. What’s interesting about this is that Fox guides to beat. Sales have consistently come in ~4% better than the stated guide. That would imply Q1 sales should have been ~$194m vs Fox now saying closer to $182m. Since they gave this guidance on 3/3, all of this shortfall must have happened in the 2H of March. By my math that suggests sales went from trending up 20% YoY in Jan through early March to down 25% in the 2H of March. This should give you some sense of the potential cyclicality. 

In sum, FOXF was an intriguing short before the current panic ever surfaced. There was ample evidence of slowing growth and earnings quality issues, in addition to a number of red flags. It has become significantly more appealing as management has doubled down on auto products and increased leverage right as we near a recession.

This report (the “Report”) with respect to Fox Factory Holding Corp. (the “Issuer”) has been prepared by the author (the “Author”) for informational purposes only. The Report contains certain forward-looking statements and opinions which are based on the Author’s analysis of publicly available information believed to be accurate and reliable. While the Author believes that such forward-looking statements and opinions are reasonable, they are subject to unknown risks, uncertainties and other factors that could cause actual results to differ materially from those projected. The Author has no obligation to inform readers of changes in such forward-looking statements and opinions and no warranty is made with respect to the accuracy or completeness of any of the information set forth herein.

As of the date the Report is published, the Author and/or certain entities (the “Entities”) affiliated with the Author hold a short position in the securities of the Issuer and therefore have a financial interest based on changes in the price of the Issuer’s securities. The Entities may increase, decrease or otherwise change their position in the securities of the Issuer based on changes in market conditions or other analysis. Neither the Author nor the Entities undertake any responsibility to inform readers of changes in such position.

Nothing in this Report constitutes investment advice. Readers should conduct their own due diligence and research and make their own investment decisions.

Catalyst

• Earnings/disappointing results led by auto products
• Covenant breach
• Re-rating as investors realize Fox is more of an auto supplier than a recreational/consumer co.