American Outdoor Brands: An Asymmetric Bet On Niche Outdoor Brands (NASDAQ:AOUT)

American Outdoor Brands, Inc. (NASDAQ:AOUT) is a leading provider of niche products for outdoor enthusiasts, primarily focused on the domestic U.S. market. The company separates its diverse portfolio of mostly early stage brands into one of four categories based on their intended use: Adventurer (knives, tents, etc.), Harvester (hunting gear, meat prep tools, etc.), Marksman (range gear, cleaning supplies, etc.) and Defender (scopes, gun cases, etc.).

Originally Smith & Wesson Holding Corp, a gun manufacturer, American Outdoor Brands Corporation was formed in 2016 after the firm began diversifying into sporting goods and outdoor gear, with firearms still accounting for over 85% of revenues. In 2020, the company was spun off from Smith & Wesson amid a hostile political climate for gunmakers and a failure by management to extract value from the slew of acquisitions in prior years.

AOUT employs a strategy combining organic growth through the development of current brands and innovative new product incubation (e.g., MEAT! Your Maker), and inorganic growth via acquisition of companies that fall under one of their four brand umbrellas (e.g., Bubba Blade). For the acquired businesses, management aims to unlock potential through their established distribution network and sales channels, and expand the acquiree’s product offering into related categories. Many of these are strong brands leading their respective niches, with few peers able to compete with the scale advantages provided by the parent company. Other conglomerate outdoor specialists share little overlap with AOUT’s product markets, and it pays to stay out of each other’s way.

While yet to prove the model as an independent company, American Outdoor Brands, Inc. management appears to have a clear vision for sustainable growth. Not only that, but they find the stock attractively priced, with continuous insider buying throughout the year by directors, executives, and the CEO himself increasing his stake by 21% back in September at $8.95 per share. Management also initiated a $10M stock buyback program in September 2022 which accounts for roughly 8% of all shares outstanding at the current price level.

Uncertainty in financial results

The company was the beneficiary of increased demand during the COVID period as consumer habits shifted and more people explored outdoor activities. Revenues increased an incredible 65% in FY21 and while still remaining at abnormally high levels, did decline 11% in FY22. This trend looks set to continue as wholesalers cut orders amid uncertainty in the economic climate, with the first two quarters of FY23 revenues only 75% of last year’s during the same period. While gross margins have remained consistently high (45-47%) across all reported quarters since the COVID shock in 2020, Q4-FY22 and Q1-FY23 saw a significant decline, averaging 43.7%, due to increasing freight costs as part of a planned inventory build aiming to combat rising material costs. Q2-FY23 saw margins return to 45.9% as the company’s subsequent reduction in inventory purchases began to take effect.

Earnings over the past few years have been more lumpy, however. In FY20 and again in FY22, AOUT wrote down significant portions of goodwill, $98.9M and $67.8M respectively, resulting in reported net losses. However, if we adjust earnings to exclude these non-recurring expenses and those arising from related deferred taxes, reported earnings are positive and significant. Looking at how well reported income translates to cash flows, we can see that recent activities regarding the inventory build led to a negative free cash flow yield of -$21M for FY22, whilst in previous years, free cash flow yield was positive. For the two most recent quarters of FY23, cash flow from operations continues to remain stable, with management using the cash to aggressively pay down the $25M of debt issued for the Gorilla Grills acquisition.

From undervalued to a fair price

While the financials may not look so bright at first glance, we can see that AOUT has steady, positive cash inflows and is well positioned for growth beyond pre-COVID. On top of this, the most recent quarter saw direct-to-consumer sales increasing 119.1% from the same period last year, indicating high demand for products, as these sales are not impacted by retailer inventory management. Despite an overall decline in revenues for FY22, the relatively small international sales segment did increase 39.6%, highlighting the potential for outsized growth in currently underserviced markets.

In terms of pricing the stock, the first thing that stands out is that AOUT is almost a net-net, with current assets minus liabilities (NCAV) equal to $105M vs. a market cap of $128M. Including the significant portion of intangible assets and PPE, it trades at an attractive price-to-book ratio of 0.64. An investment today offers very little downside assuming the company can remain cash flow positive and even a modest improvement on pre-COVID cash flows implies a much higher intrinsic value than the current stock price. Warren Buffett often reminded Berkshire Hathaway shareholders of his preference for companies that can continue to compound earnings in the long term, despite short term volatility.

Since AOUT is still in the early innings of its spin-off, with little historical data as an independent company, turbulent market conditions over the previous two reported fiscal years and the threat of a looming recession, it is quite difficult to forecast American Outdoor Brands, Inc. free cash flows with any certainty. Calculating a specific price target would therefore be a challenge and this may be another reason why it is so cheap. If you believe in the management’s growth strategy, the strength of the company’s brands and a continuing demand for outdoor equipment, in the U.S. and internationally, then the price today is a bargain.

However, until there is some certainty surrounding the market conditions and AOUT’s profitability the stock may continue to trade at depressed levels. One important catalyst going forward will be a positive net income print for FY23. Many investors exclude unprofitable companies from their investment universe. With no more goodwill left to be impaired or any other significant non-recurring expenses expected to arise in the next two quarters, a profitable FY23 looks increasingly likely. As the benefits of the inventory build out are also felt or if the company slows the rate of debt repayment, free cash flow should once again swing positive and signal to the market that compounding is set to continue. Both of these results are KPIs to look out for in the upcoming quarterly earnings reports. Any surprises reported in DTC channel strength, individual brand success or international sales growth will also indicate potential outperformance in the stock. Additionally, the $10M share buyback program should put a floor on the stock price and we have seen several sharp moves to the upside in recent months indicating large buys at around the $8 mark.

“Diworsification” and the China problem

Of course, all may not go as planned and with tight operating margins, volatile revenue numbers can lead to periods of unprofitability. Even though AOUT may be less cyclical than other similar businesses, if the widely predicted recession materializes, the company will not be spared as consumers tighten their belts and retailers respond in kind. While recent developments with respect to China easing COVID restrictions initially looked positive, rapidly rising numbers of new cases may have a disproportionate impact on AOUT due to the majority of their products being manufactured in and imported from China. The reversing trend in globalization and international relations may also create further headwinds, such as the 25% tariffs imposed on imports by the US in 2018 and recent supply chain headaches, leading to margin contraction.

Finally, with a growth strategy that hinges on continuous acquisitions, “diworsification” is an ever-present risk. Before spinning out American Outdoor Brands in 2020, the preceding acquisition spree did not appear to indicate wise capital allocation, overpaying heavily as indicated recently by the large goodwill write-downs. In addition, many of the acquired businesses exhibited high growth statistics prior to the combination but went on to stagnate under the management of the acquirer who were presumably more focused on their dominant firearms segment. Let’s hope that management will not repeat these mistakes going forward, otherwise shareholders will be on the hook.

In summary, trading near NCAV, American Outdoor Brands is a great buy at the current price if they can maintain profitability. Positive earnings and free cash flow for FY23 may wake up investors and unlock intrinsic value in the stock. Management’s growth strategy has the potential to drive outperformance and compound cash flows far into the future, but failing that, the downside risk to American Outdoor Brands, Inc. investors today appears to be minimal.