Investment Overview

West Marine, Inc. (WMAR) is an under-earning category killer retailer that is well along the way to an operational turnaround and poised to benefit from a secular improvement in underlying industry demand.  With a new CEO and Board of Directors with significant domain experience, WMAR has positioned itself to improve store productivity, expand margins, and seize on an eventual rebound in macro boating trends.  At 4.2x 2014 EBITDA, WMAR trades at a steep discount to historical multiples and other similarly situated market-leading retailers.  As topline growth returns and margins improve, we believe WMAR could generate $62m of EBITDA and garner a 7x multiple, implying upside of 76% from the current stock price.  With a cash-rich balance sheet and tangible book value of $12.12 per share, we believe downside to current levels is relatively limited, creating a highly favorable risk/reward.

About the Business

With 295 stores in 38 states, West Marine is the largest bricks-and-mortar retailer of boating supplies.  The Company sells all things boating, except the boats themselves.  Major product categories include maintenance items, electrical parts, safety equipment, and related lifestyle merchandise.  West Marine generates the bulk of its revenue from its traditional stores and related website, but the Company also operates a wholesale division known as Port Supply.  Stores average 9,000 sq. ft. but flagship and larger format stores can be as large as 30,000 sq. ft. 

West Marine is uniquely positioned in that it is the only player in the industry with a super-regional or national footprint following the 2009 bankruptcy liquidation of Boaters World.  At this point the only real bricks-and-mortar competition comes from boating-focused mom & pop shops and the national sporting goods retailers which carry only limited offerings of boating-related products.  There are several online players as well, the largest of which is Defender.com, which does ~$30m in revenue and is the low-price player in the market.  We recommend you read Madler934’s October 2009 which digs into the structural changes in the industry that have taken place since the boating market last peaked in 2005.

Background

The boating industry last peaked in 2004 and has since suffered one of the most prolonged downturns in the history of the industry.  Beginning in 2006, the industry was hit with escalating gas prices and the double whammy of hurricanes Katrina and Rita.  With the industry already reeling, the credit crisis and ensuing recession further depressed spending on new and used boats.  Industry-wide sales of powerboats, long steady at ~300,000 units a year prior to 2004, bottomed near 132,000 units in 2010.  Sales have rebounded some in the last three years, but still remain well below historical levels at 163,000 units. 

Viewed against this backdrop, West Marine’s performance held up remarkably well during the recession.  Though 2009 sales sank 18% from 2006 highs, by 2012, revenue had rebounded to close to 2005 levels and Adj. EBITDA reached levels not seen since 2004.  Recent results, however, have fallen short of expectations as cold weather – April was the coldest on record in a decade – delayed the start of this year’s boating season until late into May, forcing management to twice revise full-year guidance lower.

Thesis

Operational turnaround will drive margin improvement: For the last several years, West Marine has been in the midst of an operational turnaround aimed at jump-starting comp store sales and improving profitability.  The big initiatives include:

-  Real estate optimization:  In order to cut costs and drive more profitable stores, WMAR, since 2009, has been consolidating markets in which it has multiple stores by closing two or three small stores and replacing them with a single, larger store.  Square footage tends to remain flat.  So far, the Company has consolidated ~45 markets, shrinking total store count from 404 in 2005 to 295 as of 6/30/13.  Results have been positive.  According to management, consolidated markets tend to see a 24% jump in sales in the first year and continued improvements thereafter.  In some cases, occupancy expense increases modestly given a movement to better locations, but store-level SG&A is better utilized, and leveraged as sales improve.  All told, management claims the consolidations have achieved a 15% return on capital.  Ultimately, management plans to double the number of consolidated markets over the next 3 – 4 years, reducing the total number of stores to around 270, but increasing the number of flagship and large format stores to 90.  Given the ROI profile, we would like to see an acceleration of the consolidations, but understand management’s measured pace – during the downturn, MWAR was able to renegotiate many of its leases on more favorable terms, and in doing so, stage lease expirations within each market to coincide with one another, reducing the cost to exit stores when the time comes.

-  Merchandise expansion:  The second leg of management’s turnaround plan is to augment West Marine’s traditional boating supplies business by adding an assortment of branded lifestyle apparel and accessories to complement the anchors, ropes, radios and other equipment found in the stores.  Matthew Hyde, who took over as CEO in June 2012, was formerly an executive VP at REI, the outdoors sports company, where he at various times oversaw retail, online, real estate and marketing, including launching their multichannel strategy.  He is largely credited with transforming REI's stores from the dull technical equipment-focused outlets they once were into the lifestyle centers they are today and he’s looking to run the same playbook at WMAR.  Real estate rationalization is a key aspect of the merchandising initiative.  With bigger stores, WMAR can better accommodate the 75,000 SKUs offered by the company.  Given many of those SKUs are slow turning pieces of equipment, fewer stores means less investment in items that will sit unsold on shelves for most of the year, and more square footage and resources are channeled into faster turning merchandise.  The strategy is already showing progress.  Expansion categories currently only account for ~15% of sales, but are as much as 30% of large format stores, and they have been outperforming core categories by 800 – 1,000bps in terms of same-store sales.  Over time, these faster turning items should be key traffic drivers that help the business to perform better in times when traditional boating activity is weak. 

-  Conversion to multi-channel retailer:  The last piece of the turnaround effort is predicated on unifying the various legacy pieces of WMAR’s business into a cohesive whole.  Until recently, MWAR managed its three reporting segments – Stores, Port Supply (wholesale) and Direct-to-Consumer (online) as three distinct businesses that benefitted from some shared infrastructure.  Now those pieces are being integrated.  Take online for instance.  Until recently, if a customer came into a store looking for, say, an onboard radio, which was only carried by the online business, the sales clerk’s only option would be to suggest to the customer that he go home and order the item online.  And in fact, given that the sales clerk would receive no piece of the commission on the sale, there wasn’t even an incentive for the sales clerk to go the extra mile and make the suggestion in the first place.  That is now changing.  The compensation structure was recently changed such that sales clerks benefit from online sales to customers in their regions, and a new POS system enables the clerks to place orders directly to the online channel, before the customer leaves the store.  Soon, the two channels will be seamlessly integrated, meaning customers can buy items online or in stores, for pick up in store or delivery to their home.  WMAR is also investing in new back-end systems for the website which will enable faster, more reliable search results and fast check-outs.  At present, e-commerce contributes 7% of total sales, but the business is growing in the mid-teens to low twenties, and management thinks it can ultimately contribute 20% of total sales, in line with other integrated retailers.

Recent results belie improving industry and company fundamentals:  Despite the positive traction WMAR is seeing on its internal initiatives, and the improving fundamentals of the broader boating sector, its last two reported quarters have disappointed, missing plan and forcing management to lower 2013 revenue/EPS guidance from $708m/$0.68 (midpoint) to $655m/$0.40.  As mentioned above, this year’s winter was unseasonably long, significantly impairing boat maintenance sales in the early part of the season and hampering overall boat usage.  Given the seasonal nature of the business there is little chance for an upside surprise to this year’s numbers, but fortunately this set back has no bearing on next year’s numbers and on long-term earnings power.  We also take comfort in the positive results reported by Brunswick and MarineMax.  Brunswick, the largest global boat manufacturer, has seen mid-single digit revenue growth in its Marine segment over the last two quarters.  Similarly, MarineMax, the largest retailer of boats, posted mid-teens comps over the same period.  These results bode well for WMAR as they are leading indicators of boating demand and further verify improving industry fundamentals.

Aligned and motivated management team:  In addition to a new CEO, WMAR recently added a new head of marketing with a background in e-commerce and several new Board members with domain expertise, including Dennis Madsen, the former CEO of REI, Jamie Nordstrom, who runs the Direct business at Nordstrom, and Christiana Shi, VP of Nike's e-commerce business.  The theme is clear – WMAR has built up a lot of senior leadership focused on building out its direct/multichannel business.  Additionally, Randolph Repass, WMAR’s founder and former CEO, and current Chairman, owns 26% of the stock, giving us comfort that the Board is working in the best interest of shareholders.

Attractive valuation:  At $11.01 per share, WMAR is currently trading at 6.4x our 2013 Adj. EBITDA estimate of $38m.  In a normal year, giving some benefit to its operational initiatives, sales could reach $700m in revenue and $53m in EBITDA, implying a valuation of 4.2x.  In a year where the business sees a lift from improving industry demand, sales and Adj. EBITDA could easily surpass $725m and $60m, respectively, implying a valuation of just 3.6x.  Even in our more optimistic case, we are projecting operating margins of just 5.7%, a modest figure compared to other category-killer retailers.  As comps turn positive and margins begin to improve, we believe WMAR could garner a multiple more in-line with other mature, single-category and sporting goods retailers.  At 7.0x, we see upside of 55% - 75% from today’s price.  More importantly, given WMAR’s strong balance sheet ($46m in net cash) and with the stock currently trading below tangible book value of $12.12, we see little risk of significant downside, creating a favorable risk/reward.