2023-08-11 05:42:26 ET
Summary
- Fox Factory Holding Corp has potent competitive advantages but is struggling due to macro and inventory headwinds. I remain patient for a better entry from the current 20% upside.
- The company's strategic partnerships and acquisitions have solidified its position as a leading name in performance-driven suspension and biking components.
- Fox Factory's advantages over competitors include strong brand equity and technological prowess leading to superior growth and profitability compared to peers.
Thesis
Fox Factory Holding Corp (FOXF) is ubiquitous to quality in the world of suspension. It also demonstrates strong characteristics of business quality with a compelling brand image and differentiated technological prowess. My analysis points to a 20% upside from current levels by 2024 using an exit multiple of 19x 12-month forward EV/EBIT. Although this return is somewhat compelling, I expect further weakness after the company issued weak guidance for the second half of the year.
Overview of the business and strategy
Bob Fox founded Fox Factory back in 1978; the company's roots trace back to selling motocross parts. His strong drive for racing led him to push the boundaries of suspension engineering performance, consequently designing market-leading products.
As the years progressed, FOX expanded beyond the motocross market and entered the high-performance suspension business for mountain bikes, snowmobiles, and off-road vehicles. The diversification of the product portfolio proved to be a pivotal move for the business as it established a solid footing for quality and performance, allowing it to capture significant market share. The company's strategic partnerships and acquisitions, such as the purchase of Race Face and Easton Cycling in 2014 , further contributed to solidifying its position as a leading name in performance-driven suspension and biking components.
Over the past decade, FOX has continued innovating, introducing electronically controlled suspension systems and expanding its product offerings to cater to a broader range of vehicles and applications. Across all segments where FOX participates, elite-level athletes consider FOX suspension to be the gold standard of suspension.
Segments and products
Specialty Sports Group (SSG - 42% of revenue) : SSG provides an extensive selection of performance components for mountain bikes (primarily) and road bikes, showcasing brands like Fox, Race Face, Easton Cycling, and Marzocchi. This division mainly targets the mountain biking community, supplying both mid-range and premium front and rear suspension systems tailored for various biking activities, including cross-country, trail, all mountain, free-ride, and downhill. The Race Face and Easton Cycling brands further extend their offerings with bike parts like wheels, cranks, chainrings, and pedals. Their target market is high-end bikes that cost over $2000 .
Fox Factory Bike Components (Investor Presentation)
This segment suffered terrible performance in the recent Q2 earnings release. Revenue was $400 million, reflecting a 41% decline versus Q2 2022, also missing the street's expectations by 2%. Management attributed this to a classic over-supply issue due to very limited availability just before that. People were scrambling to purchase bikes during the COVID period, and channel partners extrapolated their demand forecasts based on overshot demand. Demand for new bikes is now softer, and inventory channels are now working their way through their accumulated inventory. Management is guiding that this weakness should unwind by the end of the year. Looking ahead, considering the magnitude of this decline, I believe it will take longer than another couple of quarters to work through the channel inventory.
Powered Vehicle Group ( P VG - 58% of revenue ): This division specializes in suspension components, largely under the FOX brand, for a variety of vehicles, including on-road trucks (both with and without off-road features), off-road vehicles, motorcycles, commercial trucks, and snowmobiles. Moreover, PVG encompasses a set of brands recognized as Special Vehicle Approved Manufacturers. These brands, namely Tuscany and SCA Performance, provide enhancement kits and customization options for vehicles from Ford, Jeep, Nissan, and GMC.
In Q2 2023, FOXF introduced a new reportable segment called Aftermarket Applications Group which used to be a subsegment of the Powered Vehicle Group.
Fox Factory Brand Portfolio (Investor Presentation)
FOXF's revenue is split 63% in North America and 37% in International markets (19% Asia, 17% Europe and 1% RoW). Their sales channels are roughly 50% OEM and 40% aftermarket. In both segments, Fox Factory is going after the affluent and passionate crowd that enjoys the thrill of high performance. The company has performance in its DNA. They describe these categories as PRO, Ultra Enthusiasts, Weekend Warriors, and performance enthusiasts. They try to stay away from the mass markets where differentiation is limited, and pricing power erodes.
Competitive advantages
An edge over competitors will protect FOXF from the erosion of its high returns on invested capital. The ROIC was ~17% on average over the last five years.
Brand equity
This is unequivocally the company's biggest advantage. Fox = top performance. Especially in the speciality sports segment, the majority of top athletes compete and win using Fox's suspension and components. In the top price range of mountain bikes, Fox has over 60% market share.
Technological prowess
Fox has consistently led the market in innovating new methods to reduce shocks and converting these shocks into higher performance (speed & control). Additionally, Fox has achieved significant manufacturing at scale that improves the unit economics even for high-end performance.
Growth and profitability
Peer Revenue Growth Profile (Seeking Alpha)
Fox Factory trumps the revenue growth of all its peers across all time frames. To understand the sustainability of the growth outperformance, it's important to understand the roots of each Segment's growth. Firstly, in the bike segment ((SSG)), there is an e-bike revolution (both road and mountain) that significantly expands the market. People who wouldn't qualify as customers because of endurance and physical capabilities are now eligible to ride e-bikes. In fact, McKinsey expects this secular growth trend to fuel bike sales growth of 5-7% through 2025 . The pandemic has been another significant growth driver that created massive bottlenecks in the supply chain for bikes. Now this is reversing and, in fact, is a headwind to growth. The Powered Vehicles division has benefited significantly from acquisitions over the past ten years. In fact, acquisitions added ~10% growth CAGR to the PVG division, while ~5% was attributed to pricing. The combination of a huge wave of discretionary spending, elevated demand during the pandemic and constrained supply chains has helped both divisions. These demand tailwinds are easing, but I expect FOXF to continue outperforming the industry in the long run due to its focus on high-end categories. In the near term, the inventory channels are oversupplied, and this is evidenced by the discounts offered on Fox Factory's website.
Discounts (Company Website)
Peer Profitability Comparison (Seeking Alpha)
The profitability of Fox Factory is way ahead of its peers. The main drivers of the outperformance are the following: 1) Focus on high-end performance that carries high pricing power, 2) has a technology-led approach and over time it accumulated unmatched intellectual property, 3) has the best brand equity among peers, and finally, it has the best-in-class efficiency in manufacturing.
To illustrate the point about technological innovation, FOXF won multiple innovation and reliability awards and launched new technologies in 2012 ( Float X2 shock ), in 2016 ( Live Valve System ) and in 2021 (36 Float EVOL Fork ).
In the most recent Q2 earnings release, EPS contracted 13% Year over Year to $1.21, ever so slightly above the guided range of $1-1.2. This was marginally higher than consensus figures driven by efficiency initiatives underpinned by operational improvements at their facility in Gainesville. Operating de-leverage from the contraction of the SSG segment hasn't had a dramatic impact on profitability which is a positive sign for the resilience of profitability going forward. I expect a recovery in margins, especially when incorporating efficiency initiatives that will continue yielding saving into 2024.
Where I see incremental value
Below are some catalysts where I believe the consensus figures may be underappreciating.
US-based supply chain
The company is focused on expanding its manufacturing capacity with a new manufacturing plant in Georgia which will deliver efficiencies and ultimately lead to margin improvements.
Suspension for commercial trucking
There are rumours that Fox is studying the effects of high-performance suspension on fuel and maintenance efficiency. They are making an economic case for the purchase of expensive shocks on heavy-duty transportation vehicles.
Product mix shift to aftermarket
As the market for new bikes slows due to macro headwinds, a significant portion of sales will pivot to aftermarket products which will give margins an uplift. I calculate that aftermarket products carry a ~3% higher margin than OEM sales.
Valuation
I believe that consensus figures are a fair assumption of the likely outcomes by the end of 2024. Although growth appears lacklustre, it's a true representation of the stage we are in the economic cycle combined with the effects of the COVID tailwind unwinding.
In the Q2 2023 earnings call, management guided targeting the low end of their revenue range ($1670mn -$1700mn, implying +4.2%-6% Year over Year growth). In my valuation methodology, I assume gradual EBIT margin improvement due to reverse deleveraging as demand from SSG normalizes. Then, I apply a relatively conservative 19x Forward 12-month multiple on 2024 operating profit, which leads to a target price of $138.
Valuation model (Refinitiv consensus and Author's calculations)
While not outstanding, a 20% return by the end of 2024 is not negligible. Baked into my assumptions for the target price is also a 2-point rerating of the 12-month forward EV/EBIT multiple, but it's still well below the 22x average over the past five years.
Valuation multiples (Seeking Alpha)
Risks
Macroeconomic uncertainty
FOXF sells high-end products that are susceptible to economic cycles. If the macro clouds intensify, then demand for high-end suspension may drop more than expected.
Strategy execution
The company is building out a new manufacturing plant in the US, and expansion activities carry inherent execution risk. Additionally, FOXF purchased Custom Wheel House for $132mn earlier this year, and integration also carries some risk that may impact profitability going forward. This could be in the range of 1-2% hit in operating margin, but FOX's track record with acquisitions leads me to give them the benefit of the doubt.
Conclusion
Fox Factory has done a terrific job at diversifying its business model to include more categories than its legacy bike suspension products. It's now a best-in-class business with excellent fundamentals and strong growth prospects. Even though there are visible avenues of incremental value generation, I think it will take longer than two years to realize their effects fully. Although I wouldn't argue that valuation is overstated, I am inclined to put this idea on the sidelines until a better entry opportunity arises.
For further details see:
Fox Factory: Patience Before Pulling The Trigger