Description

RACN is currently at $3.25 which is only about 4.3 to 5.6 times the $0.58-$0.75 in EPS the company is projecting that they will do in 2001 (they just announced these expectations about 2 weeks ago with their Q4 2000 earnings release). At a multiple of just 10X say $0.65 in EPS, the stock is at $6.50 for an easy double. They did EPS of $0.48 in 2000. Additionally, goodwill amortization is currently hurting EPS by about $0.25 per share, so if the FASB proposal to eliminate goodwill amortization becomes effective, they will be reporting EPS of $0.83 to $1.00 based on management’s 2001 guidance. That implies a PE of 3.3 to 3.9 at current prices. On a cash flow basis, the company is trading at 3.4X year 2000 EBITDA and 3.3X year 2001 EBITDA, and at 4.5X year 2000 EBITA and at 4.3X year 2001 EBITA. At a very conservative private market valuation of 6-8X EBITA, the stock would be worth $7 to $11 per share. In addition to just being plain cheap based on 2000 actual results and based on what management is projecting for 2001, an important catalyst is that RACN has positive operating momentum. This is not a company that is at a low valuation because they are struggling to overcome some deep problem – in fact, they did have some problems a year or two ago, but they have appeared to have done an excellent job in fixing the company. Over the last couple of years they have done a significant amount of cost cutting and have been successful in paying down a significant portion of their debt, with more debt reduction expected in 2001, and at the same time have developed a slew of new products which should provide growth in 2001 and beyond. So this is a healthy business that is trading very cheaply relative to earnings and cash flow, is operating under a very lean cost structure, and is projecting significantly better results for the coming year.

Racing Champions is a producer and marketer of collectibles and toys, including die-cast replicas of racing cars, sports cars, and agricultural equipment, and other collectible items such as NASCAR souvenirs and apparel. Die-cast products were 70% of sales in 2000. About 40% of sales are through mass merchandisers such as Wal-Mart, Target, etc. while the other 60% are through other channels including hobby and specialty stores, trackside sales at auto races, as well as automobile and agricultural equipment dealers. Currently about 15% of their total sales are NASCAR related and NASCAR die-cast products (replicas of cars) are 8% of total sales.

The history of RACN demonstrates how the stock got to be as cheap as it is, and why it seems very likely that the stock will be more appropriately valued sometime over the next year or two. RACN’s original focus was on die-cast NASCAR collectible cars (this is actually a pretty big business, with die-hard racing fans collecting replicas of the cars of their favorite drivers) and related souvenirs. Basically this business involves licensing the names and likenesses of NASCAR drivers and then having these die-cast cars made in China to their specifications. RACN grew quite rapidly as NASCAR became more and more popular, with revenues growing from $66 mm in 1996 to $156 mm in 1998. During this time they also developed product lines involving classic and custom vehicle replicas, licensed preschool activity toys, and sports trading cards. However, sales of NASCAR-related merchandise peaked in 1998, so to continue their growth trajectory and to provide diversification, RACN acquired The Ertl Company in April of 1999. Ertl is a well-known manufacturer of die-cast replicas of agricultural and construction equipment as well as toys. For example Ertl has a license with John Deere (as well as with Case IH and Ford New Holland) to make replicas and toys using the Deere name, which are then sold through John Deere dealerships as well as through mass marketers. To do this acquisition, RACN took on about $100 mm of new debt (they only had a small revolver prior to this acquisition). At this time, their core NASCAR business was declining very rapidly. For the year 1999, RACN’s total sales were $232 mm which was still a big increase over 1998’s $156 mm, but the increase was entirely due to the Ertl acquisition, since their core racing die-cast business was down 60% for the year and NASCAR apparel and souvenirs decreased 47%. From 1998 to 1999 RACN’s EBITDA declined from $35 mm to $26 mm. So RACN was in a situation where they had just taken on a lot of debt to acquire a new business, and at the same time their core business was declining rapidly. As a result of this situation, management cut out a lot of costs through the integration of Ertl into RACN as well as through headcount reductions and the elimination of discretionary spending, and became very cost-focused generally in their approach to operating the business. In 2000, the result was that even though their total sales declined a little (from $232 mm in 1999 to $215 mm) entirely as a result of their poor NASCAR business, they were able to increase EBITDA from $26 mm to $39 mm and EPS from $0.26 to $0.48. The 2000 sales decline was due to NASCAR-related die-cast business being off something like 72% from the prior year, offset by significant growth from all of their other businesses. This good 2000 performance in the face of such a huge drop-off in their core business, through a good acquisition and through significant cost cutting, seems to show that this is a skilled management team. In fact, RACN started their turn-around in 1999, while competitors such as Action Performance (ACTN) who faced similar sales declines, didn’t really begin the process of trying to restructure until late 2000. So at this point, RACN is a very lean operation with a tight cost structure, and their NASCAR business which has been the problem over the last several years is now down to 15% of their total business.

With their 2000 earnings release and conference call, RACN management announced their expectations to grow sales 3 to 9% in 2001 and for the next several years, and that they expect EPS to be $0.58 to $0.75 in 2001. The significant jump in EPS even though sales are going to be up only 3 to 9% is due to lower interest expense due to them paying down $17 mm of debt in Q4 2000 and more anticipated paydowns in 2001. This works out to about $40 mm in EBITDA for 2001.

So a key question is why did RACN’s NASCAR business go so bad, and will it continue to get worse from here? RACN’s last good NASCAR year was 1998, which was also the 50th anniversary of NASCAR so there was a lot of special commemorative collectible cars, which made it very difficult for RACN to sustain the sales they did in 1998, so that didn’t help. But what appears to have happened is that there was significant inventory build-up of collectible cars in the channel in 1998 and 1999, which hurt RACN as well as other companies in the industry. Action Performance (ACTN) is another company similar to RACN that has had similar problems. RACN and ACTN were both high-growth companies at the time, and appear to have been tempted to continue to show strong growth by shipping more and more products into the channel (it turns out this is especially easy to do in the wholesale channel, where there are specialized distributors who handle only these collectible cars, but in return for getting access to quantities of limited edition cars they agree to take whatever the manufacturers ship them). It appears that this excess inventory has finally been burned off in the channel (both RACN and ACTN are projecting good results for 2001, and the inventory situation can also be confirmed by talking to these distributors). Probably the third reason why RACN’s NASCAR business has been destroyed is because ACTN is really the powerhouse in the industry. A key to this business is having the popular drivers signed up, and ACTN seems to have all the popular drivers – including Dale Earhardt, Jeff Gordon, etc. So as long as the industry was growing fast, RACN seemed to do okay, but when overall growth seemed to slow down, demand for RACN’s products which were perceived as lower quality with less popular drivers essentially evaporated. However, things seem to be looking up for NASCAR collectibles in 2001. NASCAR has a new TV deal with Fox which is getting NASCAR in front of a new audience and is getting pretty good ratings so far, and the racing collectibles distributors will confirm that so far demand is looking good and inventories are lean. Dale Earnhardt’s crash and death also has raised a lot of awareness about NASCAR. Dodge has also re-entered NASCAR racing after a long absence, and that is raising awareness. RACN is “cautiously optimistic” that NASCAR will be better for them this year – but nevertheless NASCAR will not be the key driver of RACN’s success in the future, since its down to only about 15% of their revenues.

In fact, RACN has been developing lots of new products, which have supposedly been well received by their retail customers. They have a new “Outdoor Sportsman” line of products consisting of replicas of RV’s, trucks, boats, etc. that are licensed by the leading manufacturers of those products, and will be sold in outdoor shops such as Bass Pro Shops and sporting good stores, as well as through traditional mass merchandisers. They have a new “Little Muscle” product line which are plastic car collectibles made under license from the Big 3 automakers for pre-school kids. They also have 18 new American Muscle products (historical American sports cars) and 75 new John Deere and Deere Kids products for 2001.

RACN’s capital structure consists of 14.9 mm shares of common times $3.25 for a $48 mm equity market cap, plus $97 mm in debt, less $12 mm in cash, for an enterprise value of $133 mm. They did $39 mm in EBITDA in 2000 and are expecting to do about $40-$41 mm in 2001. Enterprise value to EBITDA is only 3.3. One important point about this business is that there is a fairly high level of maintenance capital. Basically they need to invest in tooling and molds each year to make these die-cast vehicles, which tend to only last for 3 years or so. Their capital expenditures on tooling and molds is approximately equal to depreciation, so EBITA is a better measure of true operating cash flow since there is a consistent and re-occuring need for capital to replace their depreciating tooling. In 2000 their EBITA was $29 mm and in 2001 it should be about $31 mm. So the company is trading at 4.3X this year’s EBITA and debt/EBITA is 3.1 (not an insignificant level of debt given that EBITA is probably the right measure of operating cash flow). Given the maintenance capex requirements in this business, a realistic private market value is probably around 6 to 8 times EBITA (not EBITDA) which results in an equity value of $7 to $11 per share for RACN. An additional value-creating catalyst is that RACN will continue to pay down their debt – they have scheduled principal payments of $3-4 mm per quarter through April 2003 when the remaining principal on the term loan is due. This effectively means that all of their after-tax, after capex, free cash flow will be going towards reducing debt. So at an average $3.5 mm per quarter of principal paydown, this activity alone will be creating $14.0 mm per year of value or almost $1.00 per share of value for the remaining equity.

One downside is that this is a seasonal business, so they don’t expect to be generating meaningful positive EPS until Q3 and Q4 of 2001. Q1 and Q2 will be around break-even in terms of EPS. So that could make shorter term investors less willing to buy the stock over the next 6 months. But in the long run, its hard to see how this shouldn’t work out. This is a very cheap company whose equity is trading at less than 50% of a reasonable private market value, and who will create more equity value going forward through debt paydowns and modest growth. RACN has gotten through its difficult period, and has demonstrated strong results for the last 2 quarters and is anticipating even better results going forward. Another point is that their product lines are based on enduring brands (e.g. Ford, Dodge, Chevy, John Deere) and basic products (cars, trucks, tractors) so its likely to be more sustainable and consistent than a “fad-driven” collectible or toy business such as one based on Pokemon or even the latest high-tech gizmo. However, they do have a significant amount of debt, so that probably represents the main risk, but in this situation where operations are in an upswing, equity investors are in a position to benefit from the leverage.

Catalyst

Very cheap on EPS, cash EPS, and cashflow. Improving performance. Continued debt reduction.