Description

Large goodwill and intangibles writedown, correction in the ammunitions and firearms markets, terrible share repurchase timing…. wait, come back! It’s got hair, but at this valuation, VSTO presents an attractive opportunity to purchase a portfolio of leading outdoor brands for a 30-90% return (vs. current prices as of write-up of ~$21/share).

Quick Company Overview:

VSTO owns and manufactures a broad portfolio of ammunition, firearm, and outdoor sports products. The company was spun out from Orbital ATK in 2015 and reports in two segments, Shooting Sports and Outdoor Products:

• Shooting Sports comprises the ammunition and firearms businesses

• Outdoor Products consists of a suite of outdoor recreation brands ranging from tactical gear to bicycle helmets to paddle boards.

• Each segment contributes about 50% of revenues based on LTM results

• Outdoor Products is a bit misleading of a name imo. A good chunk of the revenue in this segment is derived from shooting accessories such as holsters, rifle scopes, etc. It’s a rough estimate, but you could reasonably say that about ~35% of total revenues are not related at all to shooting sports (including all acquisitions to date)

• It’s important to note these are generally solid market-leading brands. You can find a more detailed overview of its products / brands here: https://www.bamsec.com/filing/161631816000147?cik=1616318

Recent Events:

• In Jan. 2017, VSTO announced that investors should expect a goodwill and intangible impairment charge of $400-450mm in its Hunting and Shooting Accessories segment due to a “softening retail environment and increased promotional activity”. (Charge ended up at $449mm). Shares promptly tanked.

• VSTO reported earnings on 2/10/2017 (yesterday) and gave very lackluster guidance, dropping FY2017 adjusted EPS from ~$2.70 to $1.92-2.10. Also, warned of continued pressure through most of CY2017 as it adjusts its inventories and cost structure to respond to lower demand in ammunitions and shooting sports related products. Shares tanked again.

• Add to this a backdrop of a volatile firearms and ammunition market as volumes are coming down down from pre-election high levels.

• VSTO has also done a terrible job of timing its share repurchases, buying back $300mm worth of stock since it’s spin-off at… well, prices well above current levels.

Acquisitions:

Mgmt team historically engaged in M&A back at Orbital ATK, but the pace of acquisitions increased in the past few years:

• 3/31/2009: Eagle Industries for $63mm (tactical gear and equipment for military and law enforcement)

• 4/9/2010: Blackhawk for $172.3mm (tactical gear manufacturer)

• 6/21/2013: Savage Arms for $315mm (long gun manufacturer)

• 11/1/2013: Bushnell for $985mm (sports optics)

• 7/20/2015: Jimmy Styks for $40mm (stand up paddle boards)

• 8/3/2015: CamelBak for $412.5mm (hydration packs and bottles)

• 4/1/2016: BRG Sports Inc's Action Sports $400mm (brands include Bell and Giro, Blackburn)

• 9/1/2016: Camp Chef for $74mm (outdoor cooking products)

Considering its recent $449mm impairment charge (largely related to its Bushnell and Blackhawk acquisitions), management’s acquisition prowess has been called into question. Given these results and an upcoming soft demand environment, M&A activity is highly likely to be put on pause and management admits as much - I view this as a good thing, management has navigated soft demand environments successfully before and I’d prefer their focus is on managing margins and organic business in the upcoming tough environment.

Financials:

Earnings: Keep in mind that the financials are messy due to all the acquisitions (please also note FY end is 3/31 of said year):

* $7mmm start-up cost tied to DoD contract in FY12: https://www.bamsec.com/transcripts/4784095?hl_id=nkopng8oz
** Estimated incremental public co costs: https://www.bamsec.com/filing/95015715000108/2?cik=1616318

Segment Results: Shootings sports consists of the ammunitions business and rifle business (Savage Arms) while the Outdoor Products consists of a range of outdoor recreation products (including shooting accesory products such as holsters and also non-shooting sports related brands such as CamelBak). Again, these segment figures are highly impacted by acquisitions.

Ammunitions and Firearms Exposure:

It would be false precision if I presented a very detailed rationale of where I think firearms / ammunitions sales will go. But let’s try to sense check where volumes could go by looking at the below chart showing firearm and ammunition excise taxes since 1996.

We’re at above-trend levels of industry activity, but I also doubt that things collapse to early-2000s levels and stay there - especially as political winds change and gun regulation once again becomes top of mind. There are obviously a wide range of where ultimate firearm and ammunition sales could end up normalizing to, but sales declining to around 2010-2012 levels is within reason. There are also mitigating factors that should help VSTO’s ammunitions-focused business in particular (~85% of VSTO’s Shooting Sports revenues are pure ammunition, the rest comes from rifle manufacturer Savage Arms),

• VSTO has been consistently increasing share in the ammunition market going from (<30% to 35%+ market share from 2003 to 2015)

• The most recent surge in the firearms industry (past 1-2 years) has been primarily firearms driven (ammunition was driving things in 2013-2014 when ammunition stockpiling was an issue)

• The ammunition business has also benefited from a real trend towards increased target shooting which has very likely boosted the base-level of demand for ammunition in the US. (Downside is that target bullets are typically cheaper lower-margin bullets).

• Ammunition purchases should in theory be more consistent than larger ticket gun purchases, especially in these industry downturns

Normalized Earnings / Valuation

The next few quarters will quite possibly continue to be ugly with gross margin pressure as the company adjusts to a new normal in firearms / ammunition (and related accessory) sales as a Republican government takes power. The relevant question to us is where earnings power goes in CY2018 after the nearer-term inventory / margin / cost issues are worked through.

If we believe that the CY2010-2012 timeframe is where the ammunitions / firearms industry settles out to than the question is what VSTO managed to earn during those periods. Corresponding to the 2010-2012 timeframe is VSTO’s FY11-13. During FY11-13, VSTO’s business largely consisted of ammunitions and shooting accessories products. Let’s call the business that constituted VSTO during these pre-acquisition spree years the “Base” business. The results for this Base business during those years show on average  ~$110mm in adjusted EBITDA (for context, I estimate that the Base business generated ~$150mm+ in adjusted EBITDA during FY2016).

Next, we consider earnings from VSTO’s post-2013 acquired businesses. We can estimate EBITDA based on disclosed purchase price multiples and also haircut Bushnell and Savage Arms earnings.

• We haircut Bushnell’s estimated acquisition EBITDA due to it’s recent goodwill impairment and its exposure to shooting sports (about ⅔ of its business is providing firearm-related accessories)

• We haircut Savage Arms due to the cyclically weak firearm environment (although there are reasons to believe that Savage will outperform expectations due to less volatility from it having a big hunting rifle focus and also only very recently entered the moderning sporting rifle (MSR) world)

Layering the normalized $110mm Base business EBITDA with our marked acquired EBITDA gives us:

• Downside case supposes that the ammunitions and firearm market correction is much sharper than expected and bakes in additional weakness for the post-2013 acquired business

• Upside uses acquisition EBITDA instead of marked EBITDA for the post-2013 acquired businesses

• As a collection of leading brands with reasonable long-term growth prospects, we believe a multiple of 14x levered FCF / share is appropriate. This is especially true if you view the shooting sports category earnings power described in the below valuation to be closer to trough than mid-cycle (which is a reasonable belief in our opinion):

Risks

- Bad acquisitions (although this has largely been taken off the table near-term)

- Further goodwill & intangible writedowns (More of an optical risk, but still possible)
- Ammunitions and firearms (and related accessories) markets correct much harder and faster than expected (fully expect this upcoming year to be ugly, and while possible, a prolonged period of extremely low ammunition and firearms purchases seems unlikely to me in the long-run given our volatile political climate and VSTO has some mitigating attributes (discussed above) and has proven it can make money in significantly lower ammunition volume environments).
- Lake City contract renegotiation runs into issues. VSTO sources .223 / 5.56 ammunition through Orbital ATK's Lake City facility. (contract is up for renewal in 2018 and discussions are underway. All commentary suggests renewal process suggests relationship on both sides is good, but at worse, .223 / 5.56 is commodity-like and can be sourced elsewhere and is even possible to manufcture in VSTO's own plants (although incremental investment in re-tooling lines would be required).

Catalyst

- Back half of 2017 / 2018 earnings when VSTO has an opportunity to adjust to new lower demand environment and demonstrate that underlying earnings power is not as bad as feared.

- Share repurchases.... actually this is unlikely near-term given RP covenants, but could be possible several quarters out.
- Activist involvement: Get someone to bring some more discipline to the long-term capital allocation strategy of the company... selling a unit or two to generate cash for a tender offer at these levels would certainly be nice