VSTO - Escalade: Time To Step Back (Rating Downgrade)

2023-08-15 17:25:28 ET

Summary

• Escalade's share price has skyrocketed, but its fundamental performance has weakened.
• Revenue has declined by 25.2% due to weaker demand and excess inventories.
• Net income, cash flow, and EBITDA have all declined as well, and the company's valuation is expensive compared to similar firms.
• This all implies that upside is limited, if it exists at all, from here.

In this world, there are only a few things that the vast majority of the population has in common. One of the greatest commonalities amongst us is the love of games in some capacity. So it would stand to reason that a company that focuses on the production, import, and distribution, of games, would have the potential to thrive. One such firm that has done incredibly well from a share price perspective in the past several months has been Escalade ( ESCA ). For those who don't know, the company focuses on a very specific segment of the gaming market, largely centered around sporting goods with brands such as Bear Archery, Ping-Pong, and Goalrilla, under its belt. But even as the share price of the company has rocketed higher, fundamental performance has shown real signs of weakening. Given these two factors, I've decided to take a more cautious approach to the business moving forward. This has led me to downgrade the company from a ‘buy’ to a ‘hold’.

Stellar appreciation

The last article that I wrote that involved Escalade as the primary focus was published in November 2022. In that article , I recognized that the company was experiencing some mixed financial performance. Most of the data, in fact, was looking rather bearish. This led me to conclude that the near-term outlook for the company could be negative, with bloated inventories and broader economic issues weighing the stock down. But even in spite of this, the stock was incredibly cheap, leading me to be optimistic from a return perspective. Ultimately, I ended up rating the company a ‘buy’ to reflect my view that shares should experience upside that would be greater than what the broader market would achieve. Truth be told, the business far exceeded even my own expectations at that time. Since the publication of the article, the S&P 500 is up only 10%. By comparison, Escalade has seen upside of 67.6%.

Given this massive return disparity, you might think that the driver behind this performance would be strong fundamental growth. But that couldn't be further from the truth. Take, as an example, the revenue the company has generated. During the first half of the company's 2023 fiscal year, sales came in at $124.7 million. This represents a decline of 25.2% compared to the $166.7 million in revenue generated one year earlier. This drop, according to management, we just driven by weaker demand following the end of the pandemic and by excess inventories in retail.

Even though management has not really provided much additional detail besides this, I can say that I have seen other companies that experienced a surge in demand for their offerings as a result of the pandemic. And in those cases as well, the end of the pandemic ushered in a new area of weakness. The main example that comes to mind is the RV space. Which considering the overlap between it and a company like Escalade in terms of themes, makes a lot of sense. This especially rings true when you consider that management stated that demand was particularly affected when it came to things like archery, basketball, and both indoor and outdoor games.

On the bottom line, the company saw some weakness as well. Net income in the first half of the year totaled only $2.7 million. That's a substantial decline from the $12.3 million reported one year earlier. In addition to suffering from a decline in revenue, the company also saw its key cost categories worsen. For instance, cost of products sold totaled 77.8% in the first half of 2023. This compares to the 73.7% reported for one year earlier. The drop in gross margin was driven by a less favorable product mix, continued inventory issues, higher handling costs, and other related factors. Selling, general, and administrative costs, also increased, climbing from 15.1% of sales to 16.1%. This was not an area that management really provided much in the way of additional details on. But it is likely that some combination of higher fixed costs in relation to revenue and perhaps increased advertising on a percentage of revenue basis, played a role.

Net profits weren't the only area that suffered. The company also saw its cash flow figures worsen. At first glance, you might be tempted to contradict me. In fact, operating cash flow went from $274,000 in the red to $12.9 million in the green. However, if we adjust for changes in working capital, we would see that cash flow was slashed from $17.3 million to only $6.9 million. Meanwhile, EBITDA for the company fell from $20.8 million to $9.3 million. When I last wrote about the company, we did not yet have data covering the end of 2022. So for context, in the chart above, you can also see 2022 data compared to 2021. The key takeaway from this is that revenue is virtually flat while profits and cash flows declined to some extent. But it was not as drastic as what we have seen so far this year. So clearly, the picture is worsening.

Unfortunately, management has not provided much in the way of guidance. But if we annualize results experienced so far for 2023 we would expect net profits of $4 million, adjusted operating cash flow of $10.2 million, and EBITDA of $14.5 million. Using these figures, we can value the company on a forward basis. The results can be seen in the chart above. Also in the chart, you can see valuation data using results from 2022. What I think is very important to point out here is that, if we assume an eventual return to levels seen in 2022, shares of the business still look fundamentally appealing. But because of the pandemic effect, we don't have any strong evidence to suggest that this will come to pass.

On a forward basis, shares of the company do look very pricey. This is true, not only on an absolute basis, but also relative to similar firms. In the table below, for instance, you can see how I compared the company to five similar firms. On a price to earnings basis, Escalade ended up being the most expensive of the group. It was also tied for the most expensive using the EV to EBITDA approach. And when it comes to the price to operating cash flow approach, four of the five companies ended up being cheaper than our prospect.

Takeaway

From all that I can see, the picture for Escalade looks quite painful at this time. I am happy to see that shares of the business far exceeded my own expectations. But given the data that we are seeing today, combined with how shares are priced, I must take a more cautious approach. Because of this, I've decided to downgrade the company from a ‘buy’ to a ‘hold’, reflecting my new view that the stock will probably generate performance that more or less matches the broader market for the foreseeable future. In fact, in the near term, I wouldn't be surprised if it underperforms to a modest extent.

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