Broken Merger, Priced Right
In December 2020, Sportsman’s Warehouse (NASDAQ:SPWH) agreed to an acquisition by Great Outdoors Group, LLC for $18.00 per share. Prior to the announcement, shares traded at $12, then immediately popped to $17.90. For almost a year the merger seemed aimed for completion. However, by December 2021 it became clear an ongoing FTC investigation would derail the transaction and as a result Great Outdoors walked away. We are now left with a broken merger, but not a broken company. Sportsman’s Warehouse has seen consistent growth over the past five years, and trades at a conservative EV/EBIT multiple under 4x. Precedent transactions in the same space reveal mergers around 8x, implying approximately 100% upside under conservative assumptions.
As a sporting goods retailer, Sportsman’s Warehouse has been the beneficiary of the post-pandemic movement to outdoors. Moreover, the political climate circa 2020 included a strong pull-forward in the hunting & shooting category, historically representing over 50% of the Company’s sales. In not-so-surprising fashion, both the post covid outdoor theme and the heightened politically sensitive climate have persisted, leading to outsized growth and upsized projections. Consider management’s commentary in the most recent quarterly presentation:
As compared to the second quarter of 2019, same-store sales were up nearly 32%. Our hunting category performed above expectations during the second quarter, driven by sales of firearms in certain categories, which benefitted from political rhetoric and elevated media exposure. […] Seasonal demand for these products remains strong as consumers continue to participate in outdoor activities such as hunting and shooting sports. Comparing our hunting and shooting category to 2019, it has increased 61%.
There’s a lot to unpack here. First, the pent-up demand of outdoor experiences has continued from 2021 into 2022, with reason to believe it’s a long-term trend. Management for competitor Dick’s Sporting Goods (DKS) mentioned similar news in their last conference call, citing consumers that have made “lasting lifestyle changes focused on health and fitness, sports and outdoor activities”. Having done some research in the RV space, I’ve seen the outdoor trend expand to more diverse crowds young and old, supplementing an investment thesis in SPWH.
Second, political rhetoric seems to no longer be a “one-off” event. Rather, it is a streaming consciousness that permeates our current climate. For better or worse, over the past five years background checks have increased by 10% per year. Although 2022 will see a decrease in checks, the long-term trend continues to be positive. At the same time, the outdoor life isn’t all politics: there’s reason to believe the number of hunters is growing, leading to stronger efforts in conservation and preservation of land across the country. Management sees Sportsman’s Warehouse as a “steward of the outdoors”; and works with communities to build relationships.
Both the move to an outdoor lifestyle and the overarching political rhetoric are complementary trends for Sportsman’s Warehouse, signified by the increase in sales mentioned above.
Notably, while there was a 10% drop off in year over year same store sales versus Q2 2021, the bull whip isn’t enough to crush the company on valuation. Moreover, the merger proxy reveals that the business has already surpassed internal projections, and now expects ~8% growth per year through 2025.
Our opportunity stems from what was a merger between Sportsman’s Warehouse and Great Outdoors Group (corporate parent of Bass Pro Shops, Cabela’s, and White River Marine Group), which emerged circa December 2020. When negotiations were ongoing, Great Outdoors was willing to pay $19.50 per share for SPWH; however, due to the political climate, internal plans for a distribution center overlapping GOG, and cash required to fund inventory, Great Outdoors reduced their offer to $18, and added a go-shop period. SPWH management agreed, and the Company was well-shopped with over 39 potentials. Eventually, Great Outdoors provided the superior offer, and upon announcement SPWH shares popped 40+%.
For the next year shares rarely traded under $17, implying a strong probability of deal closure with relatively little risk. Yet when an FTC investigation came to the fore in December 2021, Great Outdoors saw the writing on the wall and decided to walk away. Shares plunged to $11, and created an opportunity. Broken mergers happen: but when the underlying business remains valuable and industry tailwinds sustain growth, it creates a fine opportunity to pick up shares at value-based prices.
Why does the opportunity exist?
In addition to price insensitive merger-arb traders callously bailing on SPWH, we can further identify the company value through the merger proxy, specifically relating to precedent transaction analysis. On page 60 we get a list of past transactions in the retail sector, including Cabela’s acquisition of Bass Pro Shops, among others. Out of 15 deals, the average Adjusted EBITDA multiple was 8.7x, and the median was 7.8x. That provides us with a solid foundation for relative valuation, given current SPWH price and financials.
Next, we require some inputs to establish EV/EBITDA multiples. From the most recent balance sheet, we obtain the following line items: $6 million in cash, $90.8 million in short debt (revolving credit line), no long-term debt, and 42.2 million shares outstanding. At a price of $9, we obtain an Enterprise value of $464.6 million.
We’ll use the 2021 Annual Report to obtain yearly EBITDA numbers. Sportsman’s Warehouse reported $144.2 million, $1.4 million, and $26.5 million in earnings before taxes, interest expense, and depreciation & amortization, respectively, for a total of $172.1 million. Notably, let’s subtract the one-time $55 million payment from the merger termination, leaving $117.1 million in EBITDA.
At $9/share, SPWH trades at 4x EV/EBITDA. Comparatively, Baird indicated the highest transaction multiple of 12.7x, implying a price target of $33.23 per share. The average and median multiples would imply SPWH prices of $22.13 and $19.63, respectively. The lowest multiple transaction from the proxy was 5.1x, when Sycamore took Staples private. Sportsman’s Warehouse is far from the troubled Staples business, yet even that conservative multiple would imply a price of $12.14.
Valuation and Guidance Digressions
Recently, management updated their projections, which included $1.9 billion in revenues and $180 million in adjusted EBITDA for fiscal 2025. We can get a little more technical here, and create a matrix of various EV/EBITDA multiples in order to reverse engineer some share prices . Below is a table demonstrating valuation using 5.1x, 8x, and 12.7x multiples against $160, $180, and $200 million in EBITDA:
Since the above table represents internal projections for 2025, I’d prefer to discount the prices by 10% annually over a 3 year time frame. Doing so – at an 8x multiple with $180 million in 2025 EBITDA – yields a present day price of $24 per share.
Never Trust Management Projections
I’ve seen my fair share of grossly misstated management projections, and I’ve learned to take a future forecast with a grain of salt. That said, why would I accept them here? Two reasons come to mind. The first stems from the merger proxy. Back in 2020 management predicted $1.3 billion in sales and $95.7 billion in EBITDA for 2022, looking two years out. In fiscal ’21 Sportsman’s Warehouse eclipsed both of those projections with $1.5 billion in sales and $117 million in EBITDA (ex-termination payment). Given the blow out in projections, I’m willing to lend some credence to the business exceeding management expectations down the road.
Secondly, there is certainly a long-term trend going on in which more people want to experience the outdoors and all that comes with it. Naturally the hunting and shooting category will continue to be an extension of that. But that doesn’t tell the whole story. There are big box retailers that unequivocally avoid firearm sales. For example, companies like Dick’s Sporting Goods & Amazon (AMZN) stay away from hunting & shooting entirely, while Walmart (WMT) restricts their sales. Outside of Bass Pro/Cabela’s, Vista Outdoors (VSTO) – as a manufacturer, and other small businesses, there aren’t many major competitors for Sportsman’s Warehouse. I’d go so far as to argue that a natural oligopoly is forming.
What Are The Risks?
Being a small cap company, Sportsman’s Warehouse is susceptible to volatile stock moves, and any investment entails both market risk and single stock risk. The former could be explained in the form of higher interest rates and macroeconomic devilry. The current course of demand destruction invariably leads to less consumer spending. In the case of Sportsman’s Warehouse, I should point out that much of their sales are consumer excess; not luxury spending, but leisurely activity. The real question is: how much will a garden variety recession affect hunters and sportsmen spanning the middle of the country? I don’t know the answer to that.
The latter single stock risk tends toward the growth projections mentioned previously. Again, I always take management’s statements with a grain of salt, but, even if the business doesn’t achieve 8-10% annual growth through 2025, I take solace in the conservative valuation at ~$9.00 per share. Moreover, an investment in SPWH is an investment in a natural oligopoly, providing some cover should the business slow down. At the very least, if I make myself price sensitive and time insensitive, I won’t lose money in the long run.
Under certain assumptions – 8x EBITDA, excluding the $55 million termination payment – Sportsman’s Warehouse can be valued at double the price it trades today. If we accept future positive growth and assume that management’s own projections can be eclipsed, then we can discount back to present value at a standard cost of equity to achieve upside more in the vicinity of 200-300%. The advantage to an investment in SPWH is three-fold. First, it’s a broken merger, creating forced selling in an otherwise healthy business. Second, conservative valuation dictates that the single stock risk is relatively small, even if the next few years don’t go as planned. Third, the trend toward outdoors, hunting, and sporting continues to grow, and the natural moat around Sportsman’s Warehouse offers a unique opportunity to ride the wave.