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American Outdoor Brands (NYSE: AOBC) is a gun manufacturer that has a storied history tracing back over 100 years. Over its history, American Outdoor Brands has solidified its place as a trusted gun manufacturer that sells firearms at reasonable prices. Its scale, cost advantage, and top quality management team have allowed it to weather bouts of excess firearm supply, inventory, and other periods of industry stress and cyclicality. Today, the AOBC stock is at a bargain value of US$9.06 per share on account of a cyclical decline in revenues, profitability and cashflows. These bad news came within a context of heightened fear of global recession. In our view, the equity is worth at least US$23.0 per share, providing investors with the opportunity to pick up an American icon at dirt cheap prices.
American Outdoor Brands' (NYSE: AOBC) roots can be traced back to 1852 when Horace Smith (inventor) and Daniel B. Wesson formed a partnership to develop magazine arms for the Volcanic rifle . The Smith & Wesson Company was renamed Volcanic Repeating Arms in 1855 after it was purchased with funding from Oliver Winchester. By 1856, both Smith and Wesson left Volcanic Repeating Arms to run a new company that would design and manufacture the new revolver-and-cartridge combination under the name Smith and Wesson. The new type of firearm was a pistol that had interchangeable parts, repeating action, revolving magazine, metallic cartridges, and an open cylinder. Following Wesson's re-purchase of Smith's interest in 1873, the company went through several owners. According to the company's 10-k, "The Wesson family sold Smith & Wesson Corp. to Bangor Punta Corp. in 1965. Lear Siegler Corporation then purchased Bangor Punta in 1984, thereby acquiring ownership of Smith & Wesson Corp. Forstmann Little & Co. purchased Lear Siegler in 1986 and sold Smith & Wesson Corp. shortly thereafter to Tomkins plc ."
At the time of the sale to Tomkins plc for US$112.5Mn, a wall street journal article reported that the company had: 30 percent share of the American pistol market - the world's biggest - with 68% of sales to individuals and the rest to law-enforcement agencies; a 1983 peak in profits of $22.2Mn on sales of $110.7Mn (20% profit margin); steady profits at about $14Mn in the three years leading up to the sale; pretax operating profits of US$14.1Mn on sales of US$116.1Mn in the 12 months ended June 30, 1986 (12% pre-tax operating profit margin).
Smith and Wesson was then purchased by Saf-T-Hammer Corporation from Tomkins plc for US$45Mn including debt in 2001. The purchase was made after the company found itself in a distressed situation subsequent to when the CEO made a deal with then U.S. President Bill Clinton. Under the deal, the company would implement changes that would limit gun distribution to qualified persons, and increase gun safety in exchange for a "preferred buying program" to offset the anticipated loss of revenues resulting from a boycott. A campaign organized by the NRA and NSSF led to a nationwide boycott by wholesalers, retailers, and some customers and the near bankruptcy of the company. Shortly after the boycott, the company had to suspend most of its manufacturing and layoff more than 100 employees -- 15 percent of the workforce, and the CEO was out.
Through a combination of organic growth and acquisitions, the company has since become more diversified, with their fingerprint on several product categories within the outdoor sports segment. Today, the company is a manufacturer and designer of consumer products for the shooting, hunting, and rugged outdoor enthusiast. They sell handguns, modern sporting rifles, and handcuffs in the United States. They also build hunting rifles, suppressors, and accessories such as knives, cutting tools, sighting lasers, shooting supplies, tree saws, and survival gear.
American Outdoor Brands can be segmented into two business units based on the type of product they manufacture. The larger segment is "Firearm Products and Manufacturing services" which accounts for approximately 74.1% of company-wide sales for fiscal year 2018. Within the firearm division, the largest category is hand guns ( revolver and pistol ) with the second largest being long guns ( rifle, shotgun, muzzleloader, etc.). Outdoor products and accessories which represent products such as cutting tools, knives, tree saws, and survival gear accounts for 25.9% of sales. This business line has been built mostly through acquisitions.
American Outdoor Brands (NYSE: AOBC) has taken investors on wild rides over the last 3 years. Since the stock peaked at US$29.68 per share back in August 2016, it has lost nearly 70% of its value. While this loss in market value is remarkable when taken at face value, data dated before August 2016, show that this volatility is true to form. The stock price have gone through many peaks and troughs over the last 21 years, reflecting primarily the cyclical nature of the industry and its business.
Revenues and operating profits followed a similar trajectory as the stock price did, with revenues being less volatile. At the end of April 2018, the company registered revenues of US$606.9Bn, which is 32% below that registered the year before, and 16% below that registered two years prior. Over the last 16 years, revenues have declined 3 times, making the probability of seeing a down year approximately 25%. Operating profits have been several times more volatile than revenues. At the end of April 2018, operating profit was 86% below that of last year, and 83% below levels seen two years prior. Over the last 16 years operating profits have declined 5 times, giving us a 31% probability of seeing a decline in operating profits.
The outdoor sports industry captures the retail and manufacture of guns, knives, camping equipment, and accessories. Through the Small Arms Survey, the Graduate Institute of International and Development Studies highlighted some of the key characteristics of the US firearms industry. Although much has changed since the end of the study period, the structure of the industry has remained unchanged, a fact that can be confirmed by looking at recent estimates from the Bureau of Alcohol, Tobacco Firearms and Explosives.
Firearm production by US manufacturers has been highly cyclical, particularly in the pistol product segment. Annual firearm production volumes fluctuated between 3.0 million and 5.0 million per year between 1986 and 2008 but have gone up consistently since then to 9.4 million by 2015. The handgun sub-segment exhibited similar volatility where total production declined by 61% to 1.02 million in 2004 from the high established in 1993 but has since gone up by well over 300%. At the same time, the rifle segment remained stable from 1986 until 2008 but has increased significantly since then. Firearm imports has displayed similar cyclicality except that it has seen a more steady rise in volumes over the period 1986 to 2016. According to the Small Arms Survey, imports have taken an increasingly larger percentage of total domestic firearm demand, increasing from 20% in 1989 to 35% by the late 2000s. Imports of firearms have increased from 701k in 1986 to approximately 5.1 million in 2016.
Over the years, the low barriers to entry has facilitated a lot of entry and exits into and out of the industry. On the other hand, practically all of the entries and exits have happened among sub-scale operators - with less than 1 million annual unit production volume. The three largest operators - Sturm, Ruger & Co. Inc., Remington, and Smith & Wesson - have dominated. The Small Arms Survey mentioned that of the 30 pistol manufacturers that produced over 100k units per year in 1986, only 19 of them remained in business by 2010. At the same time, the top three companies have consistently ranked in the top 3 in each of the product segments over the period, with each of these companies producing over 1 million units of firearms per year. There have also been considerable mergers and acquisitions in the industry, which have contributed to the concentration of supply around a few key players.
Each key player has ensured that they are king in a particular product segment. The report notes that the revolver sub-segment is a stable duopoly "dominated by Ruger and Smith & Wesson", which have been the top two producers since 1986. The top four revolver producers have remained virtually unchanged since 1996. The rifle market is essentially a monopoly where one parent company controls, through many subsidiaries, more than 1/3 of the market at the end of 2010. The shotgun market is seen as a duopoly, with the two leading sellers, O. F. Mossberg/Maverick and Remington Arms, controlling 91% of the market in 2010.
The American Firearm Industry slowed significantly in late 2016. Firearm sales declined precipitously, on the back of weaker than expected consumer demand across the industry. The weaker than expected demand led to excess inventory across the industry, forcing retailers to sell guns at rock bottom prices to get rid of excess inventory, and manufacturers to cutback on production and offer discounts. The stress in the industry could be seen across the supply chain. At the gun manufacturer stage, we saw the Bankruptcy of the 200-year-old American Icon - Remington Arms. Remington was owned by private equity firm Cerberus Capital Management and had debts and assets of between US$100m to US$500m. At the distributor stage, we saw the bankruptcy of United Sporting Goods Company (USC) which operates five distribution centers and is owned by private equity firm Wellspring Capital Management. At the time of the Bankruptcy filing, USC said it had between US$100Mn and US$500Mn of liabilities and cited excessive discounting as partly responsible for the insolvency.
Monthly FBI background checks also indicate that there has been a marked slowdown in the number of gun purchases as on a historical basis the number of background checks correlates with the number gun purchases. At around December 2016, signs of a slowdown in firearm demand began to manifest after almost a 2- year run. This downturn in demand coincided with the period in which the stock began to falter, and company profitability across the industry began to show signs of weakness. Although industry demand remained strong, the 2 year run in demand led many companies to expand capacity in anticipation of great future demand. When demand did not grow as expected, the resulting excess supply forced many companies to begin production cutbacks and aggressive discounts to get rid of excess inventory.
We have seen a number of reasons why investors should be ultra cautious when venturing into this industry. On the other hand, American Outdoor Brands has a number positives that position the company well in normal market conditions. As outlined before, the firearm industry is highly cyclical with intermittent periods of excess inventory, and huge discounts. In addition, while brands do play a role in the consumer's decision-making process, there is very little product differentiation and very little manufacturing secrets. In this context, goods in the firearm industry are near commoditized products with most of the gap between true commodities and firearms attributed to branding. Evidence of the fact that these products are near commodities can be seen in the small pricing power that gun manufacturers have, as excess inventory build-up are often followed by massive price discounts.
AOBC's key strategic advantage comes from its scale and scope. As one of the three largest gun manufacturers in the USA, the company is able to operate at a lower average cost than most. In addition, the broader range of products being manufactured positions the company to spread the overhead costs associated with marketing, product development, raw materials across greater volume. In times of economic stress, the company is able to slash prices on its products to levels that are at or below the competition, which helps the company to keep or expand market share while still generating cash. This is an enviable position that many other competitors can only dream to accomplish.
On a conference call back in mid 2018, Chief Financial Officer Jeffery D. Buchanan said AOBC would:
limit advertising to sustain market share, rather than gain market share, and seek to expand market share through new products alone.
The management team led by James Debney has been laser-focused on maintaining the company's market share. The large market share allows the company to strategically maintain one of the lowest cost in the industry all while keeping the level of competition manageable.
We think AOBC is trading at a 55% discount to its intrinsic value of US$23.0 per share, which give us the possibility of making just over 100% return on investment over a 3 to 4 year holding period. In our view, a discount cash flow model is most appropriate to determine the intrinsic value of the stock given that the business and the industry is currently in a cyclical downturn, there is only one other publicly traded comparable firearms manufacturer, and the number publicly available precedent M&A transactions among comparable companies is limited.
Using a discount cash flow analysis, we discovered that the the cyclically adjusted unlevered free cashflows of the company are expected to average around US$93.5Mn over the next 10 years. The business is expected to sustain a growth rate of about 3%-4% over the long run, though there maybe intermittent periods of cyclical volatility in revenues, profitability, and cashflows. A weighted average cost of capital of about 9.0% is appropriate in the context of a cost of equity of about 11.5%, a pre-tax cost of debt of approximately 6.5%, and a debt to capital ratio of 40%. The company issued bonds in 2018 at par at a coupon rate of 5.0% which supports the 6.5% pre-tax cost of debt used, and over the years the company maintained a debt to total capital ratio between 37% and 48%. The required return on equity is materially above the expected return from the market, reflecting some degree of conservatism, and the additional risk that comes from investing in a small cap to a mid-cap cyclical company (see our discount cashflow analysis, replace your assumptions with your own and see how the valuation differs).
There are downside risks to the valuation due to the uncertainty around sales growth and margins, but we think that the current trading price of US$9.06 per share provides adequate downside cushion in the event that sales and margin expansion are less than anticipated. First, our baseline forecasts assume a 10-year CAGR in sales of about 6.3%, which is higher than the assumed long term sustainable sales growth about 3.5%. This is so because we believe that the business is currently at the trough of the business cycle, and will recover in the years ahead as it has done in the past. In a scenario, where sales growth remains subdued at around 3.5% for the next 10 years, the computed intrinsic value will go to US$15.6 per share, which is still higher than the current trading price. Of course, sales can decline further after declining by 32% in the fiscal year 2018, but even in that kind of scenario we would have to see aggressive double digit declines before we begin to see intrinsic value fall below the current share price.
Over the last 16 years, gross margin hit a low of 23.37%, averaged 33%, and hit a high of 42%. We assume on average 34% gross margins over the next 10 years, which is slightly higher than historical average to reflect the fact that the company has made several acquisitions that have led to margin expansions, and have also invested in infrastructure that has and will support additional cost savings going forward. Our DCF model shows that gross margins would have to sit at about 27.5% for 10 years before the computed intrinsic value falls to the current share price. Corporate overheads relative to sales have been on a consistently declining trend, reflecting various cost savings initiatives, additional scale, and better management of production and demand. In April 2002, research and development and selling general and administrative expenses were 38.3% of sales but were brought down to 19.4% over the following 12 years. With the downturn in the industry, we have seen this trend up quite a bit to 28% of sales in the last 2 years. Our model assumes that these overhead costs trend downwards to about 20% of sales during our forecast horizon. Nevertheless, in the event of a 180-degree turn of company strategy for these overhead costs, where they are allowed to be 5 percentage points higher than forecast, the computed intrinsic value will fall to about US$14.25 per share which is still materially higher than the current share price.
A special note should be made about the risk that rising interest rates pose to our valuation estimate. The assumed weighted average cost of capital is about 9.0%. If monetary conditions tighten substantially we could see the cost of capital run pass the 10% used in our sensitivity analysis. In this scenario, the current low stock price provides room to absorb such shocks up until crisis levels. The current monetary environment is highly unusual and so extraordinarily high interest rates is possible which could depress valuations significantly.
American Outdoor Brands is priced very conservatively in the market today. This is somewhat understandable given that this business is highly cyclical, sells discretionary goods, and that there are ideas of a recession floating around. In our view, the equity is worth upwards of US$23.0 per share even after adjusting for business cyclicality. In scenarios where either sales growth turn out to be less than expected or margin levels turn out to be softer than planned, the current stock price provides ample cushion to protect assets while investors wait to see what cards are in the deck. The company is also a cost leader in an industry that has low barriers to entry. Management is laser-focused on maintaining market share, which together with a cost leadership position and huge scale make AOBC very tough to dislodge. All in all, this equity provides the opportunity to make a buck while undertaking limited downside risks.