Description

Overview

Vista Outdoor is both a CEO change story and a cycle-recovery story.  This ammunition and outdoor products company was written up on VIC back in February.  Since then, the stock is down 30%, bringing the cumulative peak-to-current decline to 70%.  The empire-building CEO who led its poorly executed acquisition-strategy has been replaced by an executive with experience building consumer products brands (which former CEO lacked) and 9 years as a Managing Director of a multi-billion private equity firm.  Just one month into job, Vista’s new CEO slashed expectations (timely move - 2/3rds of his equity package hasn’t been priced), announced plans to divest 3 non-core brands, and set the stage for a meaningful SG&A-reduction program. 

Meanwhile, the ammunition cycle is 12 months into the downturn, channel inventories are normalizing, firearm and ammunition demand haven’t collapsed to the extent that bears expected, the November 2016 Presidential election has just been lapped and continued Republican control of Executive and Congress looks less certain. 

Today, Vista is valued at $1.85 billion (versus $4.2bn at peak) and at just 80% of sales, well-below private market multiples for well-invested consumer product brands and even further below the $2.3bn it paid for the acquisitions Vista made just since 2013 (note – the Ammunition business Vista/ATK owned prior to investing this $2.3 billion averaged $110mn in ebita in the 4 years ending March 2013).  On an earnings basis, Vista trades at 9.8x trough ebitda and 14x ebita, with the opportunity to double margins as SG&A is rightsized and sales recover cyclically over the next two years.

Detail

Vista was the subject of a good writeup by lzmos in February 2017, which I recommend reading.  That report provides a good overview of the business and the factors that caused the stock to decline from a peak of $50/share in mid-2016 to $21/share in early 2017 (vs $14 today). 

In brief, Vista is a consumer products company that was spun out of Orbital ATK in 2015 with an acquisition strategy designed to take what had been a legacy ammunition company and diversify it into the broader outdoor products industry.  The former CEO of ATK led the spin and the acquisition strategy, spending $2.3bn between 2013 and 2016 on diversifying acquisitions of outdoor product brands.  In hindsight, Vista not only overpaid for these businesses, but they did a terrible job integrating them, leading to significant management turnover at the acquired businesses and market share loss.  Management compounded its poor capital allocation decisions by spending $300mn on share repurchases in 2015 and 2016 despite significant evidence that the business was deteriorating. 

In November 2016, the election of Donald Trump as President significantly exposed Vista’s missteps, as it precipitated a cyclical decline in ammunition demand and highlighted the significant inventory build that had occurred pre-election at both the retail and wholesale levels and by the consumer him/herself. 

Since then, a substantial inventory de-stocking has occurred, leading to meaningful declines in Vista’s volumes, pricing and gross margins.  Consensus ebita (excluding Vista’s substantial amortization expense) for its fiscal year ending March 2018 is just $133mn, down 55% from what Vista earned in fiscal 2016.  The consensus ebita margin of 5.9% is half the 12.0% earned on average between 2010 and 2016.

Ultimately, in July, CEO Mark DeYoung was deposed as CEO.  Three months later, Vista announced the appointment of Chris Metz as CEO (https://www.prnewswire.com/news-releases/vista-outdoor-names-christopher-t-metz-as-chief-executive-officer-300532090.html). 

Chris spent 13 years at Black & Decker, including serving as President of the Hardware and Home Improvement Group from 1999 to 2005.  After leaving Black & Decker, he spent 9 years as an MD at Sun Capital, a multi-billion private equity firm.  From 2014-2017, Chris served as the CEO of snowmobile maker Arctic Cat.  In fair disclosure, Artic Cat was not a successful stock during Chris’ tenure.  Chris will tell you that he inherited a host of problems when he took the role and that ultimately the value maximizing strategy was to sell the business to Textron.  Given this blemish, it is important that you do your own work on whether Chris is the change agent that Vista needs.

Thesis

• Our investment thesis has the following components.
• Ammo cycle bottoming
• CEO Change - New CEO is much more equipped to manage this portfolio.
• Expectations reduced to much more reasonable levels.
• Balance sheet risks overstate
• Tax-reform – a freebie.

Ammo Demand

We believe the ammunition cycle is bottoming.  While adjusted NICs checks – a concurrent indicator of firearm demand and a reasonable proxy for underlying ammunition demand – are down 10% ytd, demand has held in much better than the bears expected.  For those without background in this sector, many predicted that the Republican sweep in the 2016 elections would cause firearm demand to collapse back to pre-Obama administration levels.  This has not happened, however, as the main underlying drivers of firearm demand remain intact (rising interest in target shooting, safety concerns, 2^nd Amendment believers).  Timing-wise, with the November 2016 election moving into the 12 month+ rear view mirror, we expect that NICs checks will begin stabilizing starting in December, which we believe would do a lot for investor sentiment.

Moreover, we believe that much of the inventory build that occurred leading up to the election has been worked off.  Vista has transparency into inventory and point-of-sale data from its retailer and wholesaler customers.  After several quarters of lamenting excess product inventories that have led to orders below retail levels and substantial price competition (at the retail, wholesale and OEM levels), Vista recently stated that big-box inventories have returned to normal and that wholesaler inventories are slightly above normal.  Once inventories normalize (which management expects to occur by the end of the March quarter), purchases can begin to reflect underlying demand, which we expect will restore revenue growth. Returning to revenue growth will have an outsized impact on margins as VSTO has been operating at 80% capacity utilization. Additional volume should benefit gross profit margins as incremental margins have typically been in the ~35% range.

CEO Change

We believe the replacement of Mark DeYoung with Chris Metz is a clear upgrade and will be the catalyst for substantially improved capital allocation and execution.  We believed that Mark lacked the consumer products expertise to run the acquired Outdoor Products brands.  Ammunition is not a typical branded business, with substantially less emphasis on marketing and innovation than usually seen in consumer products businesses.  Conversely, Chris brings a long background in the consumer products industry – from Black & Decker, his time at Sun Capital and Arctic Cat.  This should be a significant upgrade.  Moreover, we believe that Chris brings a fresh set of eyes to management’s prior decisions, as evidenced by his quick decision to sell the Bolle, Serengeti and Cebe brands, and management’s hints that an SG&A reduction would soon be forthcoming (note – SG&A, excl. amortization, is running at 15.8% this calendar year, 200bps above management’s estimate of a more reasonable level).

Expectations reduced to much more reasonable levels

Consensus revenue expectations for fiscal 2019 (March) assume mid-single-revenue growth versus f’18 and 7.2% ebita margins (vs 5.9% in f’18).  Given that sales, gross margins and pricing have been substantially impacted in f’18 by lower capacity utilization and fixed cost absorption and substantial discounting, we believe there is a lot of room for margin to recover as/when the destocking phase ends.  Note that ebita margins averaged 12% over the 2010-16 period, double this year’s expected result.

Balance sheet risks overstated

We believe the current valuation -- 80% of sales for a portfolio of consumer products brands with pretty good competitive positions – reflects substantial investor concern regarding Vista’s balance sheet.  Vista’s leverage ratio is expected to approach its 4.75x covenant as earnings deteriorate in the second half of this fiscal year and its leverage covenant steps down to 4.25x from March 2019. 

Nevertheless, we believe that investor concerns are overstated as we expect Vista’s banks will provide it with needed covenant relief rather than forcing a viable branded business into raising equity at the bottom of the cycle (note – the banks already provided Vista with such covenant relief this cycle).  Moreover, Vista recently announced the sale of its sports protection brands. Based on industry comps (10x ebitda, 1x sales), this would reduce leverage by 0.25x.

Additionally, VSTO has substantial inventories and accounts receivables that it is working to turn into cash over the next few quarters. The company completed another round of layoffs in October to further slow production, which is negatively impacting margins, but benefiting free cash flow. Based on our expected sales trajectory, we expect working capital to boost free cash flow by $70-100mn over the next six quarters with further opportunity to lower inventories if sales worsen. On top of this, we expect a substantial cost reduction program to be announced next quarter.

Tax-reform – a freebie

Lastly, while we would not rely on tax reform to justify an investment, were there to be a reduction in the US corporate tax rate along the lines of what is currently being proposed, Vista’s earnings would increase by 15% and improve cash generation, benefitting the company’s leverage ratio through greater cash generation.

Price targets

Base Case: By FY2020, we believe sales will recover to $2.3bn (which assumes the $130mn sale of prescription eyewear assets, $2.43bn pro forma vs. $2.25bn midpoint of FY2018 guidance) and EBITA margins will recover to 8.5% vs. historical margins of 12%+ from 2010-2016 through a combination of cost rationalization, implementation of the announced ammunition price increases, fixed cost absorption in facilities, and softening of promotional activity in outdoor products.

Our base case price target of $25 (80% upside) is based on 11x FY2020 EBITA of $195mn with the equity value benefiting from $320mn in cash generated over the next six quarters: $130mn from the sale of prescription eyewear assets, and $190mn in free cash flow.

Downside: VSTO is clearly heavily leveraged. We don’t believe the company is headed for bankruptcy and that by selling the prescription eyewear brands for $130mn+ and generating the 100mn+ of FCF over the next two quarters, bankruptcy risk will be largely taken off the table. Additionally, the company has more receivables and inventory than net debt, so we believe covenant extension is a feasible, albeit expensive, option if the trajectory worsens.

With that in mind, our downside target price is $11, which assumes sales continue to fall to $2bn in FY2020. In this downside scenario, the company is unable to improve margins significantly, generating only a 6.6% EBITA margin (vs. 5.9% in FY2018), benefiting from reduced SG&A expenses offset by demand continuing to fall in ammunition and a continued decline in the outdoor products business. The equity benefits from working capital reduction driving similar FCF in FY2019 as FY2018 and the $130mn sale of the prescription eyewear business, generating over $350mn+ of cash in total over the next six quarters.

Risks

Channel disruption:  E-commerce is clearly negatively impacting outdoor products retailers – all one needs to do is look at the financials of Dick’s, Gander Mountain (since liquidated), The Sports Authority (since liquidated), Hibbert or Academy. It is no small task to navigate the disruption that e-commerce is placing on bricks and mortar retailers, including developing a successful go-to-market approach in an omni-channel world. Channel disruption could cause more impairment charges in the future. Problems in outdoor products brands more structural than we imagine.  While the brands that Vista acquired were generally strong ones (Camelback, Giro, Bell, etc), there has been a lot of management turnover in these businesses and their capabilities will need to be assessed and, in many cases, rebuilt by Vista under Metz’s leadership.

Additional channel disruption or execution challenges could cause more impairment charges in the future. Vista took impairment charges in the hunting and shooting accessories and sports protection segments during their third quarter release, and estimated that their outdoor recreation and firearms segment were just 5% above book value.

Leverage:  As a result of ebita declining by more than half and meaningful share repurchases on the way down, the business is significantly leveraged. Vista’s leverage ratio stands at nearly 4x ebitda and will continue to step up for the next two quarters.  Through March 2019, the business is working against a covenant of 4.75x ebitda, at which point that number steps down to 4.25x.

Commodity Prices: Copper, Lead, and Zinc prices are the main inputs for ammunition have all increased significantly over the past year. Vista enters forward purchasing agreements which will begin to roll off over the next few quarters, and will have a hand in driving gross margin compression in the back half of FY2018. If Vista cannot raise prices to offset the commodity price pressure as planned, then margins in shooting sports will be lower until commodity prices fall. Copper is the main input has increased significantly over the last year, but is still below levels in 2010-2013 when VSTO earned adequate gross margins in the shooting sports business.

Customer Bankruptcies: Vista Outdoor has a number of customers that are struggling financially. Gander Mountain was the most recent big box chain to go bankrupt. VSTO suffered a $17mn A/R write down as a result of the bankruptcy. The remaining big box chains seem to be in better financial shape, but there is clearly still risk in further bankruptcies largely from Academy and somewhat in Sportsman’s Warehouse. Beyond big box customers – the wholesale distributors also pose a bankruptcy risk. There have been rumors of these distributors being in a challenging financial shape, largely caused by excess MSR inventory.

Catalyst

• Sale of prescription eyewear brands (before year end)
• SG&A Rationalization (next quarter's call)
• Stabilizing NICS Checks (winter / spring)
• Increasing NICS Checks (Summer / Fall)
• Improvement in Outdoor Products