New Addition to the Portfolio: $SPWH

Yet another value retailer

“Roughly two decades ago, a brilliant investor wrote a book on how to make money off of special situations, with a focus on spin-offs. Since then, every aspiring investor has read this book and the opportunity set has been picked over, leading to compressed returns. “ -hkup881, AKA Harris Kupperman

Having studied some interesting spinoffs over the last two years, and even investing in a few, I largely agree with Kupperman’s assessment on the current spinoff environment. Now, I search for securities that have similar dynamics as one being spun off. Specifically, a security where the seller is selling for some irrational or uneconomic reason. I believe that Sports Man Warehouse (ticker SPWH) fits that bill.

Background:

Sportsman’s Warehouse is a hunting and outdoor store based out of Utah. The company has 122 stores across the with a heavy concentration on the west coast. It earns half its revenue from camping and fishing gear, along with outdoor apparel and footwear. The other half comes from selling guns and ammunition. According to the company’s SEC filings, it is the largest gun seller in the United States.

In December of 2020, the company agreed to be bought out for $18 a share by Great American Outdoors, which owns the Bass Pro chain. This deal would have combined the two biggest gun sellers in the United States. Almost a full year later, both parties decided to back away from the deal given anti-trust concerns from the FTC. Since then, the stock has traded in a tight collar of $9-$11. I believe that most of these selling has occurred for reasons non-fundamental reasons respective to the business (i.e merger arbitragers cutting their positions) creating an attractive opportunity for long term investors.

Store Economics:

How did SPWH become the largest gun dealer in the United States? Ironically, this size was achieved by their willingness to enter smaller markets. SPWH targets markets where the big box competitors, like Dicks and Bass Pro Sports, cannot economically compete. In fact, 60% of SPWH’s stores are in markets where there is no other nationwide competitor. These include locations in Soldotna, Alaska (Population: 4,400) and Camphill, Pennsylvania (Population: 7,800). These towns are simply too small and rural to support a big box retailer like the ones mentioned above.

However, there is still demand for camping, hunting, and other outdoor gear. This is where SPWH’s value proposition comes in. Sportsman Warehouse enters these markets by opening stores with a tiny footprint, usually between 10-35k square feet. These small sized stores translate into outsized financial returns. SPWH guides to 10% EBITDA margins and a 20% ROIC on new stores. Over the past 5 years, SPWH has added an average of 10 new stores a year. Most of the company’s store base is located on the west coast and flyover states. In recent years, Sportsman has began expanding to the east coast with new stores in Florida and Pennsylvania, with management believing that they can grow to 300 stores across the nation.

Pre-COVID, SPWH’s store numbers were, well, less than impressive. The company posted SSS of 0.8%, -6.9%, 1.5%, and -0.9% from 2016 to 2019, along with a steady decline in EBITDA margins from 9.6% to 6%. What exactly caused SPWH to struggle so much? The answer lies in the competitive landscape during that time. In wake of the 2018 Parkland Shooting, Dicks announced that they would begin to phase out guns and ammunition from their sales inventory. At the time, Dick was the largest national gun seller in the US. As they exited the market, Dicks began to fire-sale their leftover inventory at prices significantly below market value. SPWH obviously couldn’t keep up in the price war, and had no real incentive to participate, considering the short-term nature of it. This led to less foot traffic for SPWH, which would drag on their sales and margins, as evidenced above. 4 years later, Dick has almost completed their exit of the gun and ammo, leaving SPWH as the dominant player in the industry.

Management:

For the most part, management keeps a low profile and doesn’t exactly blow you away. While there is nothing wrong with boring, I will offer a few positive nuggets. First, I was impressed by management’s process for site selection for new stores. Management utilizes a variety of algorithms to determine potential markets before inspecting these areas firsthand. According to their most recent investor day, the company has at anytime at least 100 potential locations in their new store funnel. The CEO also mentioned how when it comes to entering new markets, the company isn’t afraid of using secondhand retail space, like an old Stein Market, and converting that into a new store, instead of building a new store from the ground up. Second, management personally bought shares days after the merger fell through. While no one purchased a significant amount, it’s always nice to see management aligning themselves with shareholders. Third, management has clearly shown a willingness to reward shareholders given their attempt to sell the company, another nice feather in the cap.

Why the Market is Wrong:

So why else does this opportunity exists? Besides the indiscriminate selling I described above, most market participants doubt SPWH can continue their historic pandemic performance. During FY 2020, SPWH saw its sales increase explode by 60% and EBITDA hit record high. Pandemic lockdowns and nationwide civil unrest caused demand for guns to more than double from the year over. Further social distancing and travel restrictions also served as a boon for their camping and outdoor lines.  

So why is this demand shock not a one-off event? While I don’t expect SPWH to grow sales at 60% over the next few years, I do think that COVID has created a secular shift in gun ownership and the outdoor recreational space. Unlike previous gun demand surges, this one was driven primarily by first-time gun buyers entering the market. According to market data, over twelve million people have become first time gun owners over the past 18 months. Once you buy your first gun, you’re substantially more likely to another. 20% of first-time owners go on to buy a second and the average number of guns owned is 5. Gun demand continues to remain elevated from pre-pandemic levels as national background checks were up 20% in the month of February compared to 2019. Management has consistently reiterated that demand is not likely to return to 2019 levels, a view also echoed across by other gun manufacturers.  Not only are you more likely to purchase another weapon, but you’re going need something to load and fire that gun with. Ammunition sales help create a steady stream of repeat customers for Sportsman Warehouse. Furthermore, buying ammunition online is notoriously complex depending on your state’s laws. This amazon proof dynamic only strengthens SPWH competitive dynamic and value proposition

Financial Projections and Final Valuations

In my valuation, I projected that 2022 same store sales decreased by 20%, followed by same store sales improving by 2% until 2025. I also projected that SPWH would add 8 new units each year over the next three years. Finally, I assumed that SPWH’s EBITDA margin would normalize around 8% during that time frame and trade at 7x EBITDA. Using these, I get to an equity value approximately at $20 in 2025, which represents an IRR of 20%.

I made these projections by assuming that gun sales would decelerate in 2022 as demand begins to cool along with the rest of outdoor space. This would only be a temporary breather though. As management has indicated, they don’t expect gun and outdoor gear demand to return 2019 levels. We’re in the early innings of a renaissance in outdoor activities in the United States. This can be seen in same store projections of 2% in the following three years. My store growth assumption is bit low, but this is mostly because of current supply-side mayhem. Finally, I modeled margins them returning to 2017 levels, before the price war with Dicks.

It's important to note that I didn’t include any special dividends or buybacks in my model. As the merger fell through, SPWH was paid $60 million dollars by American Outdoor Group, leaving the company debt free. Looking through their SEC filings, this appears to be the first time SPWH has ever had a net debt position of 0. With store growth being funded through CFO, capital returns seem like the logical conclusion with that cash. However, I wanted to err on the side of conservatism and decided to leave it out.

Above all, I like this investment for two reasons. First, the share price has been hammered for non-fundamental reasons, as merger arbiters cut their position in wake of the FTC blocking the merger. Second, competitors (I.E Dicks), have exited the industry for non-fundamental (i.e political) reasons. This has left SPWH as the dominant player in market rejuvenated over the last two years and only expected to grow. I think this is a compelling opportunity for value and long-term investors at $11 a share. I have added $8,000 of it to the portfolio.

Note: This transaction was completed on 3/18/2021 for $11.49 a share.