BRP INC DOO.
December 05, 2014 - 6:15am EST by
wjv
2014 2015
Price: 26.00 EPS 1.551 1.894
Shares Out. (in M): 39 P/E 16.8 13.8
Market Cap (in $M): 3,087 P/FCF 11.1 8.4
Net Debt (in $M): 909 EBIT 303 356
TEV ($): 3,996 TEV/EBIT 13.2 11.2

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  • Manufacturer
  • Canada
  • Broken IPO
 

Description

Quality company with 40% shorter-term upside (catalyst 12 Dec), 80% longer-term upside

 

Investment Case Summary

Bombardier Recreational Products (BRP) is a Canadian manufacturer of powersports vehicles (Ski Doo snowmobiles, Sea Doo jet skis, Can-Am side-by-side vehicles, etc). The stock has suffered in recent months from the market rotation out of mid-caps, disappointing H1 results, and a lack of investor patience for disappointing results given that this is a recent IPO. Our research shows that the weaker H1 results were largely driven by weather (severe winter, late summer) and discounted inventory clearing ahead of numerous new product launches in H2. We also found evidence that the new products have been well received by dealers and clients and that the channel inventories are empty. This should help generate substantially stronger H2 results and a recovery in the share price. The stock has stabilised in recent weeks around C$24 and the key short-term catalysts is the announcement of Q3 results on December 12th. However, BRP is not just a short-term trade. We also like the longer-term fundamentals with the company operating within a favourable industry structure and likely to deliver 25% revenue growth, 40% earnings growth and double-digit CFROIs over the coming 3 years, while the stock is reasonably valued at 12.4x FY15 P/E, 6.9x EV/EBITDA and 0.9x sales.

                       

Company

Bombardier Recreational Products (BRP) is a leading manufacturer of ‘powersports vehicles’. The company reports results alongside 4 product segments:

Revenue %       Segment                       Product                                                                        Brands

36%                  Seasonal Products        Snowmobiles                                                    Ski-Doo, Lynx

                                                            PWC (personal water craft, aka jet ski)               Sea-Doo

38%                  Year Round Products    ATV (all terrain vehicles, aka quads)                   Can-Am

                                                            SSV (side by side vehicles, aka buggies)           Can-Am

                                                            Spyder Roadset (a new type of motorcycle)       Can-Am Spyder

11%                  Propulsion Systems      Engines for above products + motorcycles        Rotax

                                                            Engines for boats                                             Evinrude

16%                  PAC                             Parts, accessories and clothing                         The brands above

 

 

Regionally, revenues can be broken down as:

Revenue %       Region

43%                  US

22%                  Canada

14%                  Scandinavia & Eastern Europe (Russia is 6%)

8%                   Western Europe

13%                  Other (EM)

 

Operations

BRP was spun out of Bombardier in 2003 and bought by a private equity consortium consisting of Bain Capital (50%), the Bombardier Family (35%) and Caisse de depot et placement du Quebec (15%). Current management was put in place and spent the past 10 years transforming BRP from a mature company focused on 2 declining end markets (snow mobiles and PWCs) to a growth company exposed to a wide range of powersports vehicles. Amongst others, management has

  • Revived mature markets / products: a revolutionary new chassis led to market share gains in snow mobiles, the launch of a lower-end jet-ski (the Spark) has revived PWC growth, the small and loss-making ATV business became a growing and profitable segment by changing the focus to the high-end market and introducing the Can-Am brand.
  • Entered new markets: SSVs, the Spyder Roadster.
  • Improved the cost base: moved 50% of the production to Mexico, transferred ideas and technologies across the different product platforms and increased the overlap in components (the parts catalogue has shrunk from 7,000 to 5,300 items despite adding numerous new products and product categories), increased platform standardisation, etc.
  • Expanded the dealer penetration: more dealerships in the US, international growth (largest international presence of the North American manufacturers – 35%), more ‘shelf space’ in the existing dealerships on the back of a wider, less seasonal product range.

 

Growth outlook

We’ve come a long way since 2003 and last year’s IPO was designed to give some of the private equity partners an exit strategy. However, that doesn’t mean we’ve come to the end of the growth story. Some of BRP’s end markets are mature, but others are growing fast. BRP is also gaining market share in most of its markets. Adding everything together leads me to expect 25% revenue growth and 43% earnings growth over the coming 3 years.

 

Seasonal products (the mature part)

Snow mobiles

  • A mature market which peaked at 500,000 annual unit sales in the 1970s and trended down since. The 150,000 units in 2010 seem to have marked a bottom and we are currently at 175,000 units per year. I expect flat volume growth going forward + 1% pricing. Canada and Scandinavia should be flat longer-term and are driven by replacement demand (snowmobiles are replaced every 3 years on average), the US is declining by 3% per year, compensated by 10-15% growth from Russia. The Russian growth won’t be there short-term (BRP has already adjusted guidance from +20% to -20%), but this will be compensated by extra-ordinary North-American demand on the back of a severe winter last year.
  • BRP is the market leader in a consolidated industry (4 players). I don’t expect them to win market share in snowmobiles, but technological superiority and brand loyalty should allow them to at least keep the current market share and grow 0-1% in-line with the end market.

PWCs

  • The PWC market peaked at 200,000 units in 1995 and came down to 75,000 units following the recession (2/3rds US, 1/3rd international). The post-recession recovery has been very slow given the nature of the product (pure luxury spending) and the low replacement demand (low usage means that most jet skis have a life span of multiple decades).
  • The observation that the second hand PWC market is 4x the size of the new market led to the insight that customers still want to have fun, but they don’t want to pay too much for a product they rarely use. That led to BRP launching the lower-end Spark in Q2, a jet ski priced between US$4,999 and $6,250, compared to $8,399-14,899 for its other models and $5,600-8,800 for a 3-year old second hand. The ability to buy a new PWC for the price of a second hand one has been a huge success (85% PWC growth following the launch in Q2), making BRP the only growing player in a flat market.
  • This growth should continue in H2 and next year as 95% of current dealer inventory has been sold, and this cheaper product might also be the key to unlocking emerging markets. The competition does not have the EM-based production base nor the technical expertise to come up with a similar product in the near term.
  • Management is guiding for low single-digit growth longer-term and double-digit growth this year. There is no guidance for next year, but I also expect a double-digit number, which will help offset the Russian snowmobile weakness.
  • Adding all year round products together, I expect 14% growth this year (company guiding for 12-16%, an increase from the 9-13% range at the start of the year) and 2% in future years.

 

Year round products (the growth part)

ATVs

  • BRP had some ATVs in 2003 but wasn’t making any money. Bain suggested that they close down the business but in the end agreed to give management 2 years to turn the business around. They refocused on the high-end only, rebranded the products from Bombardier to Pan-Am, moved production to Mexico to be able to compete on price, and ended up turning ATVs into a growing, profitable segment.
  • The overall ATV market peaked at 915,000 units in 2005 and is currently roughly half the size. High-end has been the hardest hit and continues to decline, but BRP has grown by taking market share (currently 30% of the high-end). High-end market share gains should slow down going forward, but growth should continue as BRP is starting to focus on other segments (high end is only 20% of the total ATV market). They are currently in the process of targeting the fastest growing mid-end segments (mid cc engines, 65% of the market), where they have a 5% market share.
  • Overall, BRP is guiding for low-single-digit growth going forward (versus flat growth for the ATV market). I model 2.5%

SSVs

  • Polaris has successfully positioned SSVs as the next ATVs and turned this into the fastest growing powersports market. Whereas ATVs handle like motorcycles, SSVs handle like cars. They are safer and easier to handle for functional users such as farmers, and more fun to drive for sports users. Current demand stands at around 250,000 units per year, with 90% coming from North America.
  • BRP entered the market with the commander in 2011 (targeting the sports-utility or lower power recreational segment) and has become the #2 player in its segment with 10% market share in 3 years time. They recently also launched the Maverick, which takes them into to the high performance sports market. And they plan to launch products for functional use (over 50% of the SSV market) next year.
  • The SSV market is expected to grow at 10% for the foreseeable future and BRP should outgrow that market through market share gains as they launch new products. The company is guiding for 15% growth per year, which is what I have in my model.

Spyder Roadster

  • BRP has been a BMW and Aprilia motorcycle engine supplier for a long time and was therefore thinking of launching a Can-Am branded motorcycle. However, market research showed a crowded end market where nobody makes a decent margin apart from Harley Davidson. So instead, they came up with a completely new product.
  • The Spyder Roadster is a reverse tricycle that was created for the retiring baby boom generation who is looking for the open air / freedom experience of a motorcycle, but with a safer and easier to handle machine. The end market has proven larger than originally anticipated, with 25% of current owners being women (compared to 5% for motorcycles) and 25% people who never had a motorcycle before. The other 50% reflects the original target market with the average buyer being an affluent 45-55 year old man (average income $109,000).
  • The Spyder Roadster was launched in 2007 and has quickly grown into C$300mn business (25% of the year round segment, 10% of the overall company). The company originally targeted Quebec, where they not only have a well-established dealer base and brand name, but also managed to convince the government to create a new law that allows customers to gain a ‘Spyder Roadster license’ within a day, whereas it takes 1.5 years to get a motorcycle license.
  • The product has subsequently been rolled out in the US (already 80% of sales) and the rest of Canada (20% of sales, half is Quebec). Growth going forward should come from increasing product awareness with both customers and dealers in the US and Canada, the international launch of the Spyder (initially targeting Australia and Western Europe), and the launch of the Spyder F3 (Q4).
  • The F3 is not just another version of the existing Spyder Roadster, but a completely redesigned product that targets the chopper market (2/3rds of the US motorcycle market). Amongst others, it has a ‘feet and arms forward’ position, a lower ride, exposed engine, upgraded performance, etc.
  • Management is guiding for 15% revenue growth per year for the coming 5 years, which is what I have in my model. But off the record they believe growth could easily be double this rate.

 

 Propulsion Systems

  • Rotax engines are sold externally to motorcycle, go-kart, recreational aircraft and boat manufacturers, but the bulk of production is used internally for the different powersports products. Therefore I expect growth in-line with overall company volumes.
  • Evinrude engines are used in boats. BRP has mainly been focusing on the outboard aftermarket, which is gaining market share from inboard engines. But they have recently also started to win some contracts for inboard engines with OEMs (Kingfisher and Tidewater). Longer-term growth should be mid-single-digit.
  • Shorter-term growth should be higher on the back of the OEM contract wins, but more importantly on the launch of the Evinrude G2 engine (Q3). The latter has 75% lower emissions than competitive products, 20% more torque, 15% better fuel efficiency and is revolutionary in the sense that it no longer requires oil changes, no maintenance in the first 5 years, and the design is customizable (350 combinations). Initial reviews have been very positive and the industry press is calling it a game changer.
  • So I model 8% growth this year and next (company guidance 7-10%) and 6% thereafter.

 

 Parts, Accessories and Clothing (PAC)

  • PAC has been growing at a double-digit rate over the past 2 years as BRP has widened its product offering, increased prices, and added new dealerships. Newly launched products have all come with increased PAC options, with the Spark being a good example. You can now get anything from bright colour panelling to change the look of the Spark to depth meters and storage options. And BRP is increasingly forcing dealers to add more BRP PACs instead of 3rd party PACs as their products become a bigger part of the dealer mix.
  • The company is guiding for 10-15% growth this year and growth above the BRP average going forward. I model 13% this year, 8% next year and growth in-line with company revenues after that (6%).
  • BRP doesn’t disclose separate segment margins, but says that vehicle margins are all roughly in-line (Spyder and Spark slightly lower, SSV slightly higher). However, PAC margins should be substantially higher than vehicle margins. I wouldn’t be surprise if they are twice the company gross margin of 25%.

 

Dealership growth

  • BRP sells both directly to dealers and through distributors. The deciding element is how established the dealer network is, rather than the size of the market. They have direct distribution in Canada and 18 other key countries, and distributors in a further 85 markets (including China and Russia). They use both channels in the US (1,000 direct dealers and 1,000 through distributors).
  • The company should continue to add direct relationships as well as distributors internationally, and still has to roll out a number of its new products outside North America (Spark, Spyder). Additionally, BRP is looking to expand its direct US dealer network from 1,000 to 1,300.
  • Ten years ago, BRP was a 2 product company and in areas without snow they were a 1 product company. That put them at the bottom of the priority list of US dealers, who typically carry 5-8 brands. Now that they have a much broader and more year-round product portfolio, they should be able to expand the dealership base. Designing products specifically for the US market such as the F3 should help too.
  • The 300 new dealers will mostly be based in the South and South-West, where they can sell the widest range of products. And management says they are on track to add 65-75 new dealers this year. Expanding the US dealer network by 6% per year and stocking the showroom should easily add 1% to the top-line growth per year. I do not model this separately, it just provides an extra layer of comfort that BRP can meet the segment targets.
  • 1,300 dealers seems achievable given that the 4 nearest competitors have US dealer networks ranging from 1,300 to 1,700. Also, BRP already had 1,300 dealers before the recession (300 went bankrupt).
  • The expanded product offering and the success of products like the Sea Spark should also help to gain more cloud with existing dealers.

 

So adding it all together, I expect 25% revenue growth over the coming 3 years, 6% per year beyond that. Gross margin should increase modestly on scale benefits and mix (more new products). And strong operating leverage should turn the gross profit growth into 43% earnings growth.

 

Industry structure

BRP has a number of competitive advantages

 In-house engines

  • This provides a cost and quality advantage, but equally important has led to some valuable relationships with other motorcycle component suppliers (notably BMW suppliers) and the sharing of revolutionary technology.

 

Innovation

  • BRP invented the snow mobile (originally called the ski-dog, but a typo in the brochure led to the current ski-doo brand name), the sit down jet-ski and the Spyder Roadster. More subtle, BRP has recently reinvented the snow mobile chassis (now adopted by all manufacturers), introduced the first break on a jet ski, the first reverse gear on a motor cycle, the first low cost jet ski, revolutionised the outboard engine, etc.
  • Aside from the earlier mentioned component manufacturer relationships, BRP benefits from heavy R&D spending. They spend the most as a % of sales, and therefore a lot more than smaller players such as Arctic Cat. Only Polaris outspends BRP in absolute terms.

 

Scale

  • Scale advantages in manufacturing, in distribution and as discussed in R&D.
  • Additionally, BRP benefits from having more production capacity in low cost countries (Mexico)

 

Product positioning / brand loyalty

  • The strong innovation and quality engines has allowed BRP to position itself at the higher-end of the product spectrum – higher quality, better performing and better looking products.
  • And thanks to the well positioned cost base, they don’t charge a big premium for their products. The concentrated nature of the end markets and the higher cost base of competitors has also prevented that any of the other players felt the urge to position themselves as the ‘value option’.
  • So BRP products tend to represent a good deal to most customers and therefore brand loyalty is high.

 

 

The competitive advantages are best illustrated by looking at the high market shares in existing markets (snowmobiles, PWCs), and the ease with which BRP has been gaining market share in new markets (SSV, ATV, Spyder).

 

Snowmobiles

  • There were over 100 snowmobile manufacturers at the start of the 1970s. The bulk of them disappeared during the oil crisis and today there are 4 left – BRP, Polaris, Arctic Cat and Yamaha. The latter 2 are increasingly working together (sharing chassis, engines, etc) and therefore we can probably start calling it a 3 player market.
  • BRP is the market leader with 33% market share globally, over 40% in North America and over 50% in Scandinavia. Its brand names are Ski-Doo (mass market, known for quality, comfort, innovation and the durability of its Rotax engines, mainly sold in North America) and Lynx (mainly sold in Scandinavia and Eastern Europe/Russia and known to be the best in extreme and harsh conditions).
  • Polaris has 32% market share, Arctic Cat 19% and Yamaha 16%.

 

PWCs

  • Oficially a 4 player market, but really a duopoly. BRP is the leader with 46% market share, followed by Yamaha (40%), Kawasaki (13%) and Honda (1%).
  • BRP is well positioned to gain market share going forward on the back of the Spark success.

 

ATVs

  • The category was created by Honda in 1971 (with the now banned 3-wheel quads) and they currently still have 27% market share. Other players include Polaris (31%), Yamaha (17%), Arctic Cat (9%) and Kawasaki (5%)
  • BRP is the #5 player with 8% market share, but has so far only focused on the high end (20% of the market) where they built a 30% market share. They have just launched a product for the mid-end segment (the Outlander L) and I expect to see further market share gains on the back of this. The mid-end segment is 65% of the ATV market.

 

SSVs

  • Polaris has revived the SSV market and currently holds a 42% market share. Other players include Kawasaki (13%) John Deere (12%), Kubota (10%), Acrtic Cat (9%) and Yamaha (8%).
  • BRP has only launched its first SSV 3 years ago and has managed to build a 10% market share in the sports/utility segment. They have recently launched a product for the pure sports category and plan to launch a product for the pure utility segment next year. With 50% of the market not targeted yet, I expect to see further market share growth for BRP.

 

Evinrude

  • #4 outboard engine. Other brands include Mercury Marine (#1), Yamaha (#2), Honda, Suzuki and Tohatsu.

 

What will positively surprise investors?

Strong 2H14 results

  • BRP’s earnings are generally skewed towards the second half of the year on the back of snowmobile shipments and dealers building inventory of new products for the coming year. However, the skew was bigger in 2014 than in other years because of
  • Severe winter weather leading to subdued sales of summer products in Q1 (no compensation from winter products as these were shipped in 2H13) leading to higher promotions in Q2 to clear inventory (mainly higher-end PWCs, making room for the Spark)
  • Extra marketing costs to support the launch of the Spark. Management believes that you can only launch a new product once, and therefore it is usually worth spending a bit more.
  • An exceptional number of new product launches in 2H14 (Spyder F3, Maverick X ds Turbo SSV, Evinrude G2, Outlander L) leading to more aggressive sales promotions on existing products and BRP holding back on shipping existing products, so that dealers can clear out inventories ahead of the product launches
  • Extra costs related to the ramp-up of a new Mexican plant and the transfer of the PAC distribution to a new third-party provider.
    • Consensus couldn’t have foreseen all of the issues above, but there was no doubt also an element of overly optimistic analyst models in the aftermath of the IPO. Most of the elements above translated in gross margin pressure (-470bp to 18.3% in Q2), so even though BRP beat on the revenue line, they missed on the earnings side. Investors did not take it well and the stock has corrected 25% (ahead of the market sell-off).
    • Management has kept its FY guidance, implying exceptional growth in H2 (14% revenue growth, 54% EPS growth). Investors are sceptical that they can achieve this, judging by the big valuation discount to closest peer Polaris. But I believe the company has a good chance of delivering H2 results on target.
  • Management comes across as being extremely confident in their forecasts and we should take this serious because they have strong order visibility.
  • Severe winter weather led to exceptional snowmobile demand in 2014 and dealer inventories are at record lows. This has led to strong orders for H2, and management says that a large part of those orders have already been pre-sold by dealers to end customers. They also talk about a rich product mix.
  • The Q2 sell-through rate of the Spark has been over 95%, so we should also see some inventory re-building in this segment in H2.
  • Inventories in general are below average and it looks like the promotions on the old products have successfully flushed out stock. This implies that dealers have room to stock up on the new products that are being launched, and the promotions on these new products should be limited.
  • Year round product sales have been going well year-to-date and it would be unusual to see this pattern change halfway the season, unless there would be a sizeable economic slowdown.
  • And finally, the CFO pointed towards the 40% USD exposure and the recent strength in the USD. BRP’s FX mix is complicated (see risks), but the USD is the biggest swing factor and the recent strength should provide a cushion to meet the H2 guidance.

 

Higher growth for longer

  • There is more to the BRP story than a short-term recovery in business and re-rating of the stock. The company should be able to grow faster for longer.
  • The introduction of new products (Spark, Spyder F3, Maverick, Evinrude G2), the potential for market share growth in new markets (mid- and lower-end ATVs, utility SSV, Spyder outside Canada, Spark in EM), the addition of new dealers, the increasing product penetration with existing dealers, the ongoing focus costs and efficiencies and operational leverage should all help to deliver longer-term growth.
  • I’ve been really impressed with the pragmatic management and believe that they will also be able to come up with new growth opportunities on top of what I’ve already described and modelled, and what consensus has modelled. For example, they are currently exploring Spark-type products in some other existing categories.

 

Valuation

A year ago, BRP was trading at multiples close to Polaris – 19x P/E, 11.5x EV/EBITDA, 1.4x EV/Sales. Fast forward a disappointing 1H14 and BRP is trading at multiples closer to industry loser Arctic Cat – 12.4x P/E, 6.9x EV/EBITDA and 0.9x EV/Sales (based on next year’s earnings – FY1/16).

 

I don’t expect BRP to trade in-line with Polaris – BRP’s business is more weather dependent and therefore more volatile shorter-term, there should be some discount for the lower liquidity, and the CFROI is half the 30% generated by Polaris (although Polaris’ trend is down and BRP’s trend is up). But if the company delivers good results in 2H14, I expect to see some re-rating and at least a more pronounced difference with Arctic Cat.

 

Base case

  • Rolling the current 15x FY14 multiple 3 years out (FY17 – C$2.30 EPS) gives a TP of $34.5 (44% upside from today’s C$24)
  • That implies an EV/EBITDA of 7.2x, EV/Sales of 1.0x and EV FCF Yield of 6.7%
  • I consider this a relatively conservative base case. The average analyst target is a similar $33, but they get there by applying a 17x P/E multiple (15% discount to Polaris) to FY15 consensus.

 

Bull case

  • 17x FY17 bull EPS of C$2.59 (slightly higher year round sales, higher margin leverage) gives a TP of C$44 (83% upside)
  • That implies an EV/EBITDA of 8.5, EV/Sales of 1.2 and EV FCF Yield of 6%

 

Bear case

  • A 12x multiple – below the current Arctic Cat valuation – on FY15 earnings of C$1.50. The latter is C$0.36 below my FY15 base case and includes 1) snowmobiles growing at half the expected rate (C$0.05 impact), 2) Spark sales growing at a quarter of the expected rate (C$0.02 impact), 3) new product launches delivering half the expected growth (C$0.26 impact) and BRP only adding 1/3rd of the expected dealers ($0.03 impact).
  • This gives a TP of C$18 (25% downside) and seems a very bearish scenario in a non-recessionary environment. Of course the downside could be substantially more if we would go into a recession. Earnings could easily halve as the business is largely driven by discretionary spending, and Polaris’ P/E and EV/EBITDA multiples fell to 7x and 4x respectively in the global financial crisis.

 

Other

Balance Sheet

Leverage has come down following the IPO and now stands at a reasonable C$900mn (+ a C$350mn revolver facility for seasonal use) or 2x net debt / EBITDA. Additionally, the debt has been refinanced and the company now pays LIBOR +3% with a LIBOR floor of 1%. The debt is expiring in 2019 and management told me they have no intention of paying it down early (which some brokers model). It also seems unlikely that they can refinance the debt much lower.

 

The pension fund is $C80mn underfunded. 60% of the fund is invested in equities (domestic and foreign) and 40% in fixed income / other. Management believes that a higher interest rate over the coming years will narrow the funding shortfall. The rest of the gap should be closed on the back of beating conservative return expectations (3.5-4.5%). Therefore management does no plan to make sizeable contributions in the near term.

 

There are no off-balance sheet liabilities. Most end customers finance purchases themselves and any BRP financing is done through partners (TD and NBF Group in Canada, GE Capital in most other parts of the world). Leases are not available given the fact that most of BRPs products are sold with the intention of being properly abused by the customer (words of the CEO). Snow mobiles are a necessity in the North, and any other product is usually a toy bought by affluent customers, so NPLs have remained low, even in the financial crisis.

 

Free Cash Flow

Capex should remain around the current C$175mn for the foreseeable future. The budget will largely be used to build a 3rd Mexican plant over the coming 18 months. There are no further capacity additions planned post FY16 as the production base should be able to cover a 50% increase in volumes. But the CFO indicated that there are plenty of other investment opportunities at this point in the growth phase, so we should not expect a decline in capex post FY16.

 

Management also doesn’t expect any material changes to the working capital, and therefore free cash flow is expected to grow largely on the back of operating earnings. By FY17, BRP should be trading on an EV/FCF yield of 9.3% (FY1/18).

 

Risks

Demand for new products does not materialise

  • Investors own BRP for the growth potential. If this growth doesn’t materialise, there is no investment case.
  • Ranking new product launches in order of importance: Spyder F3 (Q4), Maverick X ds Turbo (Q3), Evinrude G2 (Q4), Utility SSV (FY15), Spark (want to see continuing success), Outlander L (Q3).
  • Additionally, investors might be worried if the SSV market overall starts slowing down. Comparing the 1.4mn peak in Off Road Vehicles in 2005 (ORV = 1.2mn ATV + 0.2mn SSV) with the current sales of 0.8mn (0.4mn ATV, 0.4mn SSV) and the knowledge that historical product cycles have lasted 15 years, gives me some confidence that we shouldn’t face a slowdown any time soon absent a recession. But if it would happen, we would need to compare the market share gains of BRP to the overall segment growth to decide if the investment case still holds.

 

Discretionary spending

  • Powersports spending is mostly big-ticket discretionary spending, therefore revenues are cyclical. Sales fell 27% between 2007 and 2010 and EBITDA fell 56%. If we are going into a recession, this is not the stock to own.
  • But absent a recession, I believe the business stands out versus many other discretionary businesses. Firstly because the sales levels of many products are still substantially below their recent peak (car sales have recovered to 90% of 200-2013 peak sales, Snowmobiles are only at 69%, SSVs at 57%, boats at 20-55% depending on the type and PWCs at 43%). And secondly because BRP does not need an acceleration in economic growth to deliver good results over the coming years. It has plenty of company-specific growth drivers, such as product launches, dealership expansion and moving more production to Mexico.

 

Liquidity

  • BRP has a $C2.9bn mcap, yet I never heard of the company until I met them last week. That is partly because they only IPOd last year (May 2013) and partly because of the small free float (33% of outstanding shares) and limited liquidity (C$4-5mn a day on average).
  • Liquidity will increase going forward as Bain reduces its stake from the current 20% to 0% over the coming 1-2 years. I believe secondary placements will be welcomed rather than seen as a risk (similar to the Dollarama experience in Canada) and could ultimately lead to higher valuation multiples.
  • But obviously the illiquidity means that BRP won’t work for all funds. And if one of the above risks materialises (recession or slower growth), the sell-off in the stock might be magnified on the back of the low liquidity.

 

Russia

  • 6% of sales come from Russia.
  • Management has already adjusted its FY14 expectations for Russia from +20% to -20% sales growth and has since indicated that product demand momentum is reasonable.
  • However, taking into account the 14% devaluation of the Rubble versus the Canadian Dollar, it probably wouldn’t take that much to miss expectations. This seems well understood by the market, and as long as the company delivers on other metrics, I don’t see a Russian disappointment as a big risk.
  • Worst case, the company revises down FY guidance after the Q3 results and only mentions Russia. If that would be the case, we will need to have a good look at the strength of new product launches (which will impact Q4 more than Q3) and have conviction that they are going according to plan and that Russia is not just used as an excuse to lower guidance.

 

Weather

  • You need snow to sell snowmobiles and sun to sell PWCs.
  • Results are generally skewed towards the second half of the year on the back of snowmobile shipments and the introduction of new models for the coming year, with Q2 being the seasonal weak quarter (no snowmobiles yet and PWC shipments tend to peak in April). Weather can make the skew more pronounced.

 

FX

  • BRP produces in Canada, Mexico and Austria. Furthermore they sell in 86 countries with the main sales FX exposures being the USD, EUR, Rubble, Swedish Krone, Norwegian Krona, GBP and AUD. So FX is a big driver and calculating the impact is not straight forward.
  • However, they key USD currency is moving in our favour at the moment and management has indicated that this will be a substantial tailwind in H2. Additionally, the Mexican Peso has been flat versus the Canadian Dollar.

 

Conclusion

It is refreshing to find a company that has clear opportunities to invest and is doing so. BRP is likely to grow revenues by 25% and earnings by 43% over the coming 3 years and generate a mid-teens CFROI. Investors have been overly focused on a difficult 1H14 and therefore the current valuation – 12.4x FY15 P/E, 6.9x EV/EBITDA and 0.9x Sales – does not reflect the growth opportunity. Aside from the growth potential and the valuation, I like the pragmatic management, the optionality that they will come up with new products and beat my estimates, and the protection that comes with relatively concentrated industries. So I would be a happy long-term holder of the stock, although I believe that a substantial part of the upside might materialise over a shorter term horizon on the back of H2 results.

 

2 min videos on some of the products:

Spyder Roadster: http://www.youtube.com/watch?v=dleTkrgdk0U

Spyder F3: http://www.youtube.com/watch?v=JrjQ8ODdaJY

Sea-Doo Spark: http://www.youtube.com/watch?v=dz0Hugb--Hg

 

Disclaimer

Past performance is no guide to future performance and the value of investments and income from them can fall as well as rise. Data is for illustrative purposes only. This information does not constitute an offer, solicitation or recommendation for the purchase or sale of securities or other financial instruments, nor does the information constitute advice or an expression of my view as to whether a particular security or financial instrument is appropriate. I, my employer and/or others we advise hold a material investment in the issuer's securities.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Q3 results - Dec 12th

 

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    Description

    Quality company with 40% shorter-term upside (catalyst 12 Dec), 80% longer-term upside

     

    Investment Case Summary

    Bombardier Recreational Products (BRP) is a Canadian manufacturer of powersports vehicles (Ski Doo snowmobiles, Sea Doo jet skis, Can-Am side-by-side vehicles, etc). The stock has suffered in recent months from the market rotation out of mid-caps, disappointing H1 results, and a lack of investor patience for disappointing results given that this is a recent IPO. Our research shows that the weaker H1 results were largely driven by weather (severe winter, late summer) and discounted inventory clearing ahead of numerous new product launches in H2. We also found evidence that the new products have been well received by dealers and clients and that the channel inventories are empty. This should help generate substantially stronger H2 results and a recovery in the share price. The stock has stabilised in recent weeks around C$24 and the key short-term catalysts is the announcement of Q3 results on December 12th. However, BRP is not just a short-term trade. We also like the longer-term fundamentals with the company operating within a favourable industry structure and likely to deliver 25% revenue growth, 40% earnings growth and double-digit CFROIs over the coming 3 years, while the stock is reasonably valued at 12.4x FY15 P/E, 6.9x EV/EBITDA and 0.9x sales.

                           

    Company

    Bombardier Recreational Products (BRP) is a leading manufacturer of ‘powersports vehicles’. The company reports results alongside 4 product segments:

    Revenue %       Segment                       Product                                                                        Brands

    36%                  Seasonal Products        Snowmobiles                                                    Ski-Doo, Lynx

                                                                PWC (personal water craft, aka jet ski)               Sea-Doo

    38%                  Year Round Products    ATV (all terrain vehicles, aka quads)                   Can-Am

                                                                SSV (side by side vehicles, aka buggies)           Can-Am

                                                                Spyder Roadset (a new type of motorcycle)       Can-Am Spyder

    11%                  Propulsion Systems      Engines for above products + motorcycles        Rotax

                                                                Engines for boats                                             Evinrude

    16%                  PAC                             Parts, accessories and clothing                         The brands above

     

     

    Regionally, revenues can be broken down as:

    Revenue %       Region

    43%                  US

    22%                  Canada

    14%                  Scandinavia & Eastern Europe (Russia is 6%)

    8%                   Western Europe

    13%                  Other (EM)

     

    Operations

    BRP was spun out of Bombardier in 2003 and bought by a private equity consortium consisting of Bain Capital (50%), the Bombardier Family (35%) and Caisse de depot et placement du Quebec (15%). Current management was put in place and spent the past 10 years transforming BRP from a mature company focused on 2 declining end markets (snow mobiles and PWCs) to a growth company exposed to a wide range of powersports vehicles. Amongst others, management has

     

    Growth outlook

    We’ve come a long way since 2003 and last year’s IPO was designed to give some of the private equity partners an exit strategy. However, that doesn’t mean we’ve come to the end of the growth story. Some of BRP’s end markets are mature, but others are growing fast. BRP is also gaining market share in most of its markets. Adding everything together leads me to expect 25% revenue growth and 43% earnings growth over the coming 3 years.

     

    Seasonal products (the mature part)

    Snow mobiles

    PWCs

     

    Year round products (the growth part)

    ATVs

    SSVs

    Spyder Roadster

     

     Propulsion Systems

     

     Parts, Accessories and Clothing (PAC)

     

    Dealership growth

     

    So adding it all together, I expect 25% revenue growth over the coming 3 years, 6% per year beyond that. Gross margin should increase modestly on scale benefits and mix (more new products). And strong operating leverage should turn the gross profit growth into 43% earnings growth.

     

    Industry structure

    BRP has a number of competitive advantages

     In-house engines

     

    Innovation

     

    Scale

     

    Product positioning / brand loyalty

     

     

    The competitive advantages are best illustrated by looking at the high market shares in existing markets (snowmobiles, PWCs), and the ease with which BRP has been gaining market share in new markets (SSV, ATV, Spyder).

     

    Snowmobiles

     

    PWCs

     

    ATVs

     

    SSVs

     

    Evinrude

     

    What will positively surprise investors?

    Strong 2H14 results

     

    Higher growth for longer

     

    Valuation

    A year ago, BRP was trading at multiples close to Polaris – 19x P/E, 11.5x EV/EBITDA, 1.4x EV/Sales. Fast forward a disappointing 1H14 and BRP is trading at multiples closer to industry loser Arctic Cat – 12.4x P/E, 6.9x EV/EBITDA and 0.9x EV/Sales (based on next year’s earnings – FY1/16).

     

    I don’t expect BRP to trade in-line with Polaris – BRP’s business is more weather dependent and therefore more volatile shorter-term, there should be some discount for the lower liquidity, and the CFROI is half the 30% generated by Polaris (although Polaris’ trend is down and BRP’s trend is up). But if the company delivers good results in 2H14, I expect to see some re-rating and at least a more pronounced difference with Arctic Cat.

     

    Base case

     

    Bull case

     

    Bear case

     

    Other

    Balance Sheet

    Leverage has come down following the IPO and now stands at a reasonable C$900mn (+ a C$350mn revolver facility for seasonal use) or 2x net debt / EBITDA. Additionally, the debt has been refinanced and the company now pays LIBOR +3% with a LIBOR floor of 1%. The debt is expiring in 2019 and management told me they have no intention of paying it down early (which some brokers model). It also seems unlikely that they can refinance the debt much lower.

     

    The pension fund is $C80mn underfunded. 60% of the fund is invested in equities (domestic and foreign) and 40% in fixed income / other. Management believes that a higher interest rate over the coming years will narrow the funding shortfall. The rest of the gap should be closed on the back of beating conservative return expectations (3.5-4.5%). Therefore management does no plan to make sizeable contributions in the near term.

     

    There are no off-balance sheet liabilities. Most end customers finance purchases themselves and any BRP financing is done through partners (TD and NBF Group in Canada, GE Capital in most other parts of the world). Leases are not available given the fact that most of BRPs products are sold with the intention of being properly abused by the customer (words of the CEO). Snow mobiles are a necessity in the North, and any other product is usually a toy bought by affluent customers, so NPLs have remained low, even in the financial crisis.

     

    Free Cash Flow

    Capex should remain around the current C$175mn for the foreseeable future. The budget will largely be used to build a 3rd Mexican plant over the coming 18 months. There are no further capacity additions planned post FY16 as the production base should be able to cover a 50% increase in volumes. But the CFO indicated that there are plenty of other investment opportunities at this point in the growth phase, so we should not expect a decline in capex post FY16.

     

    Management also doesn’t expect any material changes to the working capital, and therefore free cash flow is expected to grow largely on the back of operating earnings. By FY17, BRP should be trading on an EV/FCF yield of 9.3% (FY1/18).

     

    Risks

    Demand for new products does not materialise

     

    Discretionary spending

     

    Liquidity

     

    Russia

     

    Weather

     

    FX

     

    Conclusion

    It is refreshing to find a company that has clear opportunities to invest and is doing so. BRP is likely to grow revenues by 25% and earnings by 43% over the coming 3 years and generate a mid-teens CFROI. Investors have been overly focused on a difficult 1H14 and therefore the current valuation – 12.4x FY15 P/E, 6.9x EV/EBITDA and 0.9x Sales – does not reflect the growth opportunity. Aside from the growth potential and the valuation, I like the pragmatic management, the optionality that they will come up with new products and beat my estimates, and the protection that comes with relatively concentrated industries. So I would be a happy long-term holder of the stock, although I believe that a substantial part of the upside might materialise over a shorter term horizon on the back of H2 results.

     

    2 min videos on some of the products:

    Spyder Roadster: http://www.youtube.com/watch?v=dleTkrgdk0U

    Spyder F3: http://www.youtube.com/watch?v=JrjQ8ODdaJY

    Sea-Doo Spark: http://www.youtube.com/watch?v=dz0Hugb--Hg

     

    Disclaimer

    Past performance is no guide to future performance and the value of investments and income from them can fall as well as rise. Data is for illustrative purposes only. This information does not constitute an offer, solicitation or recommendation for the purchase or sale of securities or other financial instruments, nor does the information constitute advice or an expression of my view as to whether a particular security or financial instrument is appropriate. I, my employer and/or others we advise hold a material investment in the issuer's securities.

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Q3 results - Dec 12th

     

    Messages


    SubjectAdoption
    Entry12/08/2014 02:39 PM
    MemberYG

    Thanks for the write up. Wanted to get your thoughts on adoption rates with their newer products. For example; the 15% growth in SSVs. I can see the value prop as you've outlined but that seems like a pretty massive shift in what would otherwise be a mature industry (the legacy business). So what gives you confidence in that number? Can you maybe break down where that 15% is really coming from, even roughly? As a follow up to that, should we be expecting significant SG+A on the back of that to drive adoption?

    Thanks! 

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