Description

Overview 

VSTO has two divisions, Sporting Products which deals in ammunition and Outdoor Products which deal with sporting goods accessories. They have benefited substantially from pandemic-era nervousness, boredom and stimulus payments. I expect their results will begin to mean-revert later harder than management projects in 2022 or in early 2023, and also do not expect the planned separation of the two businesses to reveal substantial undiscovered value.

Sporting Products

The proliferation of consumer firearms during the pandemic era is a well known phenomenon. It is estimated that we have gained 5 - 7 million new gun owners in the United States since COVID, with a substantial jump in female and minority gun ownership.

How many households own guns? Nobody knows for sure, but it seems about 40% of the U.S. according to various studies. This would imply ~50 million households pre-pandemic, and therefore that we got something on the order of a 10% increase in overall household gun ownership during the pandemic.

In early COVID, production stoppages came about just as global anxiety about a lawless, violent plague apocalypse spiked. As people formed long lines around gun stores, ammo became scarce. This shortage persisted even as all of the domestic ammo makers ramped production beyond historical levels and anxieties about social disorder had calmed. This has led to manufacturers claiming that demand is now permanently elevated due to the influx of new gun owners.

While more guns ensure more ammo demand, I believe there is a good chance ammo demand is not as as persistent as the manufacturers hope. One of the recurring patterns in the industry is that gun owners stockpile weapons and ammo anytime they perceive the supply to be threatened, whether due to an elevated risk of tightening federal gun controls or a lack of inventory on the shelves. Putting the politics aside, nobody wants to be the person who doesn’t have ammo when everyone else does.

This has led to many boom-bust cycles as the industry ramps during good times and then gets rugpulled once the hoarders accept there is no more shortage. Nobody knows how much ammo is floating out there, since it is a nonperishable product. But in pretty much every cycle to date, the fear that ammo will not be available has eventually abated and people have sharply curtailed purchases. This cycle appears to represent a suped-up bullwhip effect, except instead of hitting only retailers, the inventory tends to stack in consumer basements. Remember the toilet paper craze? Except this toilet paper costs $50 per roll.

The issue of gun ownership here isn’t the key issue for VSTO, but it is relevant to the bigger question of how much ammo gun-owners will demand in the steady state? NICS background checks already show a precipitous decline in gun purchases, yet the influx of 5 million+ new gun-owners will clearly have an impact on ammo demand. The question is how much?

Plenty of data suggests that the incremental gun buyer during the pandemic was disproportionately younger, female, single, and minority. All of these factors are (sadly) correlated with a weaker income profile.

https://www.norc.org/NewsEventsPublications/PressReleases/Pages/one-in-five-american-households-purchased-a-gun-during-the-pandemic.aspx

The ownership intent of gun owners matters when it comes to ammo requirements. If you own a gun for self defense, you will mostly need just a few clips worth of bullets and only fill up after you’ve drained some practice rounds. If you own a gun for sport or recreation, you are far more likely to be a consistent and heavy consumer of rounds. Based on the buyer demographic and the mix of gun types purchased (next paragraph), I believe more new gun owners are in the former category.

Very rough math suggests the majority (~65%) of guns acquired by new pandemic-era gun owners were handguns instead of long guns. This compares to pre-existing gun owners who favored long guns over handguns by approximately a 65% to 45% split. I believe that most handguns reflect a bias toward self defense, whereas long guns reflect a bias toward sport/recreation. This relationship is not at all perfect, but I believe it is directionally helpful. The demographic skew of new buyers also suggests we are not seeing an influx of new enthusiasts into a white male dominated sport, but I am speculating here and could be wrong.

Reference: https://www.ncbi.nlm.nih.gov/pmc/articles/PMC8697522/pdf/aim-olf-M213423.pdf

There is another piece of data from the same study that is helpful:

Despite guns and ammo being very expensive for the average consumer (more so now), the majority of gun owners (BOTH new and existing) are not wealthy and approx. 60% make less than $100k annually. The recent earnings season has suggested a dive in discretionary spending in goods by consumers earning somewhere in the wide ballpark of < $75k in annual income (this breakpoint is highly imprecise, but directionally right as multiple companies reported differentials across demographic regions) as inflation has taken its bite. Surveys further suggest even the higher income groups will be cutting their spending levels in time. Reference: https://www.momentive.ai/en/blog/cnbc-financial-literacy-2022/

Even if you accept that most new gun owners will never be heavy ammo users and may be disproportionately hit by inflation, what about existing gun owners? Will they be buying more ammo?

Curiously, the (very reprehensible) recent mass shooting incidents seem not to have spurred renewed gun buying. This historical pattern (which sadly causes gun stocks to pop after gun-related mass murders) is thought to arise due to expectations of more restrictive gun laws following such incidents. Relatedly, rising anxiety as a result of civil unrest or global tensions also tend to increase gun purchases - for example, the Ukraine invasion appears to have had an effect, but not large. The recent muted response suggests some level of consumer saturation (“I got enough guns and ammo for whatever happens”) or lack of purchasing power (“I can’t afford another gun and/or more ammo”)

Channel anecdotes suggest we will see some glidepath in ammo demand as enthusiasts stock up on specialized ammunition types which are now flowing through retail channels, plus some last gasp hoarding of common calibers. Most COVID-era ammo production has been focused on the most mainstream calibers - 22’s, 9 mm, etc. This now appears to be moving into balance as prices have fallen, though remain elevated, and availability has improved greatly, though still rationed by some stores. Production is now switching to more specialized ammo which was essentially curtailed during COVID to repurpose lines for more common ammo types. Certain rifle and shotgun calibers used for pursuits like game hunting, target shooting and other purposes are now beginning to return to store shelves.

Demand could drop after hunting season. Or the bottom could drop tomorrow as consumers decide paying for food and gas is the more immediate concern. This H1 has seen massive swings in consumer spending patterns month-to-month. We haven't seen the turn yet, but the next few quarters should be telling. Whatever happens, I believe the mix of the various calibers being purchased will be a tell-tale sign of whether this demand reversion thesis is correct or not.

Outdoor Products

The other half of VSTO makes bicycle accessories, golf accessories, hunting accessories, hydration accessories, well you get the idea. I don’t think much needs to be said here other than AOBC, JOUT, and various sporting goods retailers have identified current or imminent spending destruction. This is before any heavy promotionality or mis-inventorying issues have arrived.

One reasonable pushback is that the demographics for this segment is likely much better than for Sporting Products. However, how many bicycle helmets and rangefinders does one person need? The products they sell are durable equipment and do not need replenishment like golf balls, even assuming enthusiasts do not drop out of the sport.

Equity Considerations

VSTO has traded with far less correlation to the general consumer discretionary sector than many peers, which is good or bad, depending on how you intend to use it in your portfolio. SI is not high vs history. Management has sold far more than they have bought recently.

As we’ve seen with spin-offs in recent years, investors have few excuses to misprice a company like VSTO. The separated businesses are not substantially unequal in size. The ownership base for both are likely to be similar, excepting ESG considerations for the Sporting side. A general sporting goods manufacturer such as Outdoor Product has little scarcity value as yet another undifferentiated cyclical, consumer discretionary goods maker in today’s market. 

I believe the acquisition story will not be rewarded either. Unlike many consumer discretionary peers which husbanded their cash or used it to reduce shares, VSTO spent its cash windfall on acquisitions during a particularly expensive time in the markets. A key purchase was its $474 million (more w/ earnout) Foresight Sports buy at 10x possibly peak EBITDA. Maybe they will have a hit, but the US golf simulator and monitor market is highly fragmented and competitive. International markets appear even harder to win (e.g., Korea has its own monopoly).

There is an argument that the industry is more consolidated (e.g., Remington under VSTO, lots of capacity shut) and therefore more rational than in the past. So perhaps margins don’t fall as hard in this cycle due to underutilization. However, this doesn’t mean top line and gross margins aren’t about to take a big hit if demand recedes.

How big a hit? I have no idea. VSTO today appears cheap at around 5x forward P/E, with mid-high teens FCF yield and 1x leverage. Are we at the peak? Probably pretty close. Consensus has revenues continuing to climb LSD to MSD the next two years (partially buffered by inflation and acquisitions), while EBITDA and NI fall HSD to LDD. Management recognizes margins may compress, but are sanguine about retaining a lot of demand - see Investor Day. Is consensus punitive enough? I don’t know. We haven’t seen the inflection yet, so I can’t even make one of straight-line extrapolation graphs people like to see so they can nod and say “yep, it’s clear as day.”

What I do know is that gross margins are in the mid-30’s vs. pre-pandemic at low 20’s. I am guessing that top line more likely falls instead of grows as we get into 2023 (organically speaking, obviously bolt-ons can change this and guidance/consensus reflects some of this), regardless of whether we are in “recession” or not. If GMs fall anywhere near historical levels, the negative operating leverage is pretty harsh in this business. Zero to negative earnings are not far away, and they spent their cash flow windfall while holding their debt levels. Leverage multiple goes up fast if earnings tank.

I do not believe earnings get much better from here, nor are there many likely narratives which will lead investors to give them a real P/E multiple even if normalized GM and earnings hold up pretty well. I do see greater potential for 30-80% downside in the next few years than for substantial sustained upside. 

Risks

Everything management says about new gun and sporting goods consumers during investor day is correct

Alternative ammo supply constraints (Russian ammo ban actually hurts, competitor facilities blow up, collusion, etc.) keeps shortage going for longer

Spin-off financial wizardry

Hit/fad products in Outdoor side

Airdropped money or consumers spending holds up better regardless

Have you seen The Forever Purge movie?

Catalyst

Margin compression

Top line compression