West Marine: Growth Prospects and Catalysts Lead to 60% Upside Potential

West Marine (WMAR), the largest specialty retailer of boating supplies and accessories, has been selected as one of "America's 100 Most Trustworthy Companies" by Forbes magazine in 2013. According to the research conducted by GMI, a global research firm, "America's 100 Most Trustworthy Companies" usually outperformed other corporations over the long term. I believe that WMAR is not only a trustworthy company but also a specialty retailer leader in boating supplies and accessories with near-term catalysts and achievable growth strategies.

Business Overview

WMAR sells almost everything related to boating, except boats. WMAR has survived a prolonged downturn in the boating industry and began to see the light at the end of the tunnel. According to the National Marine Manufacturers Association, "New powerboat sales were up 10% in 2012, the industry's first sign of recovery, and this year powerboat sales are expected to be up another 5% to 7%." Dealerships and industry experts expect that the boating business will gradually return back to more normal levels.

Source: Compositesworld.com

Total powerboats sold were between approximately 150,000 and 350,000 from 2000 to 2009 (see above). An excerpt below from rvbusiness.com shows that the boating industry has finally bounced back from its trough in 2009.

Full-year sales in the early reporting states totaled 198,476 for the year, a gain of 2.1% from 2012, and Kloppe said that nationwide the industry is virtually assured of selling more boats this year than it did last year. In 2012, 202,403 boats were sold across all 50 states, an increase of 9.6% from 2011. It was the first time since 2009 that sales topped 200,000.

If this positive momentum continues, total boat sales may march towards 300,000 units. In the meantime, I would rather be conservative and not incorporate this positive assumption into my model. However, there is a possibility that 300,000 units can provide a significant upside for prospective WMAR shareholders.

Strong Cash Position Generated by Free Cash Flow

Although the boating industry has almost cut in half in 2009 as measured by the number of boats sold, WMAR was able to maintain a positive free cash flow throughout the downturn. At the beginning of 2009, WMAR had $7.47 million net cash. On average, WMAR could produce about $30 million cash from operating activities per year with about $17 million in capital expenditures. By the end of 2013, WMAR has grown its net cash to $48.41 million, which represents around 17% of today's market cap. (More details about cash flow statements can be found in this link.)

Sound Business Strategies

WMAR executed well with their three key growth strategies:

Ecommerce development: According to the "15/50 plan," the first number refers to their objective to grow the eCommerce business to 15% of total sales. As we all know, online eCommerce business has become more and more important to retailers with a seamless omni-channel shopping experience. That's why we have seen similar plans in Big 5 Sporting Goods (BGFV) and Hibbett Sports (HIBB). I believe that the eCommerce initiative is the right strategy for WMAR.

Store Optimization: The second number in the plan refers to the goal of sales derived from consolidated or revitalized stores growing to 50% of total sales. With store consolidations, WMAR has been evolving into having fewer and larger stores, which offer a better shopping experience for their customers. WMAR tested the concept in seven stores during 2013, and they are now confident to expand the program to more than 20 locations in 2014.

Merchandise Expansion: The eCommerce and store optimization strategies can further be supported by the initiatives in merchandise expansion. This strategy provides broader selection of footwear, apparel, clothing accessories, fishing products, waterlife accessories, and paddle-sports equipment. The following shows the increase in the percentage of merchandise expansion products from 2011 to 2013:

(click to enlarge)

Source: 10K

The below excerpt from the latest 10-K summarizes the great progress under these three key growth strategies in 2013:

As compared to the same period last year (2013 v.s. 2012), we saw positive sales growth from our three key strategies: eCommerce; merchandise expansion; and store optimization. Sales through our direct-to-consumer channel, driven by domestic eCommerce growth, increased by 15.7%. The direct-to-consumer channel represented 6.5% of our 2013 revenues, as compared to 5.5% last year. Sales in our merchandise expansion categories (including footwear, apparel, clothing accessories, fishing products and paddle sports equipment) were up 6.1%. Merchandise expansion products represented 16.5% of our 2013 revenues, as compared to 15.3% last year. Finally, with respect to our store optimization strategy, sales from stores in our optimized markets, where we have moved to a larger format store from multiple, smaller locations, were up 4.4%, during 2013. We also experienced increased sales to professional customers during 2013, primarily through our store locations, which we believe resulted from our ongoing efforts to better serve this group of customers through our store locations.

From another perspective, revenues have risen from $1.7 million per store in 2009 to $2.3 million per store in 2013. This outstanding revenues growth should be attributed to the success of the three key growth strategies.

Management Owns a Significant Stake

According to the proxy statement as of March 17, 2014, Randolph K. Repass, the founder and chairman of the board, owned 26.7% of WMAR. Together with other directors and executives, they owned 28.5%. As we all know, owner-operated companies in general perform better. No wonder that WMAR has been able to generate positive free cash flow since 2009 as it is managed with a focus on shareholder value.

Management Has Set Low Financial Targets

In the latest 2014 guidance, management gave the following projections:

• Net revenues of approximately $695 million to $710 million, an increase of 4.8% to 7.1% over 2013.
• Comparable store sales growth of 3.5% to 6.0%.
• EBITDA of $35.0 million to $37.5 million.
• Pre-tax income of $16.0 million to $18.5 million.
• Earnings per share of $0.39 to $0.45.

By using the average of the past five years' financials, such as revenues, cost of revenues, SG&A, etc., combined with a 40% tax rate, I can come up with a forecasted 2014 income statement in line with management 2014 guidance. (Please note that I utilized the five-year average to derive my $638.6 million revenue, which is lower than the management's guidance of net revenues in the range of $695 million to  $710 million in 2014.) In fact, WMAR can meet its 2014 guidance simply by reverting back to its five-year average. This tells me that management has set a very low bar for themselves in 2014. Once management proves that they can exceed their 2014 expectation, the stock price should increase. A more bullish operating performance will be anticipated and thus drive the stock price even higher.

The Bullish Scenario

For the bullish scenario, I assume that WMAR achieves the gross profit margin of 30.73%, 25.5% of sales as SG&A, and a 40% tax rate. What I assume in my bullish scenario is that WMAR can generate the best margins or ratios based on its five years of historical performance. WMAR will be capable of producing $0.90 EPS. Combined with a 16x earning multiple and almost $2 per share cash and cash equivalents, WMAR should be valued at $16 per share providing in excess of 60% upside potential.

In addition, if WMAR can attain profit margins higher than what it has achieved in the past most likely due to the three key growth strategies, together with the boating industry recovers, WMAR will have a chance to rise above my bullish scenario estimation of $16. In that case, WMAR might be able to double from today's $10 per share to $20 per share.

The Bearish Scenario

For the bearish scenario, I utilize 1.76% operating margin, which is the worst one among the past five years. I calculate $0.3 EPS. With a 16x earning multiple and almost $2 per share cash and cash equivalents, WMAR will be valued at just under $7 per share. Although this severe downside possibility exists, investors should not extrapolate this depressed operating environment by assuming that management would tolerate such horrible performance. As demonstrated by the capabilities to generate significant free cash flow since 2009, management has already proven their abilities to withstand a severe economic downturn and manage key metrics upward in said environment.

Valuation

By taking into account the long-term impact of the $1.9 million reduction in store payroll expenses and the non-recurring $1.2 million transition costs in 2013, I model $178.8 million SG&A expenses in 2014. The net profit margins will increase to 4.05%. Taking $0.69 EPS, combined with a 16x earning multiple and $2 per share cash and cash equivalents, I come up with the valuation of about $13 per share. With yesterday's closing price of $10.1, WMAR has about 30% upside potential.

The Bottom Line

Although the risk/reward profile might not make investors jump onto WMAR immediately, we have to further consider the following positive points:

- WMAR implemented their three growth strategies, and the results have already shown positive impacts on the business. Indeed, my scenarios analysis conservatively utilized the average past five years of financial data. But what if the three growth strategies drive the profit margins to be even better metrics than any years in the past? This will help WMAR to trade at or above $16 per share.

- The management has set a low bar for themselves in 2014. Once they exceed their 2014 guidance, this can act as a catalyst to propel the stock higher in the near-term.

- WMAR is a specialty retailer leader in boating supplies and accessories. Not only has WMAR successfully survived the downturns but it also generated significant free cash flow since 2009 with an owner-operated mindset whose goals are aligned with shareholders. Nowadays, industry research indicates that the boating industry has already seen signs of recovery. This bodes well for the future of WMAR.

For investors who have high risk tolerance to withstand the possible loss, the upside potential, in my view, outweighs the downside risk. Based on my valuation model, WMAR can at least generate a 30% total return. If my bullish scenario becomes a reality, there will be an attractive 60% return. With a boating market rebound on the horizon, investors should not miss the boat in WMAR. It could be clear sailing for happy returns.