KKR's Faith in Bauer Suggests Bright Future Ahead

The investment case for Bauer (BAU) is based on:

1. Very strong competitive position (downside protection)
2. Decent organic growth
3. Strong capital allocation
4. Leading to mid to high teens EPS growth
5. Trading at less than 1yr 10x forward earnings / free cash flow

There is no catalyst besides further M&A execution. At some point Bauer may start paying a dividend. The company would also fetch a healthy premium in a take-out. However, we are willing to simply be patient given the quality / valuation / growth profile of the investment opportunity (high quality, high growth, low valuation).

We believe the opportunity exists due to relatively low liquidity ($1m per day), significant PE sponsor ownership (26%), lack of coverage (no top tier brokers), and a poor ice hockey equipment market in the short term (NB: see risk section).

SPORTS EQUIPMENT INDUSTRY DYNAMICS
The speciality sports equipment industry has particular dynamics that are important to the investment case. How can a small sports equipment maker compete with behemoths such as Nike et al which have extremely successful marketing strategies, strong distribution capabilities and strong brand appeal?

Firstly, Bauer too is a very strong brand. We have talked to ice hockey players who value BAU equipment at a premium and trust the performance (any feedback from players welcome). Secondly, the equipment market in ice hockey is a rounding error for Nike et al. The market is roughly $650m in size. It is not worth allocating resources towards due to lack of scale. The Lacrosse equipment market (which BAU also leads) is worth $110m per year. Thirdly, sports equipment needs brand authenticity. There are many examples of traditional equipment brands holding on to their market positions. Apart from Ice Hockey (Bauer, Easton), there are also tennis racquets (Wilson, Slazenger, HEAD, Dunlop, etc.), boxing equipment (Everlast, RDX), and Golf (Taylor Made, Callaway, PING) amongst other.

Golf is interesting as Nike did enter that market. Note that golf equipment is a much larger global market at several billion dollars in the US alone. However, Nike struggled at first. They started making golf shoes in 1986 (apparel is easier to enter than equipment) but kind of muddled along until 1996 when they paid $40m in sponsorship to an upcoming player called Tiger Woods (Nike's stock fell 5% on the announcement). This is before Nike even had any equipment to offer (there is actually quite a bit of tech R&D involved). Woods only began using Nike equipment in 2000 (4 years into a $40m deal and 14 years after Nike started making shoes). The huge expense and time taken to break into that market would not be worth it for niche markets that BAU operates in and pursues.

Interestingly, BAU was owned by Nike before being sold in 2008 and the branding of Bauer under Nike ownership also tells a story. Nike was going to put a 'Nike Swoosh' on the Bauer skates but it was deemed to be a marketing disaster and BAU management fiercely resisted. Instead, the skates were branded Nike Bauer which was the first time that Nike had ever used a partner brand name on a product. This goes to show how entrenched the Bauer brand is. Eventually Nike saw that there were no synergies that Nike could offer in terms of scale / brand and they sold the company in 2008 to private equity.

Further evidence that there is room for successful niche equipment suppliers is that big brands are pulling out of ice hockey rather than entering. Ice hockey equipment used to be offered by 7-8 brands, this is down to 4-5 now and is expected to go down to 3-4 in the current shake-out (according to management). BAU always emerges stronger post shake-out and is unique in delivering decent performance during periods of competitive inventory dumping. Warrior (owned by New Balance) is de-emphasising hockey in favour of football. Reebok have tried selling their ice hockey business unsuccessfully. Easton has hired bankers to sell their business.

BAU'S MARKET POSITION - A CLEAR LEADER
Skates 65% (#1)
Helmets 65% (#1)
Goalie 40% (#1)
Sticks 40% (#1)
Protective 40% (#1)

REVENUE GROWTH OUTLOOK
Growth drivers:
1. Ice hockey participation rates have been rising slowly over last 10 years
2. Further market share gains
3. Leveraging tech, sourcing, distribution to expand into adjacent areas (e.g. lacrosse equipment)
Revenues have grown 13% CAGR over the last 5 years.

As discussed, sports equipment needs brand authenticity. This impacts BAU too; their ice hockey brand authenticity does not necessarily translate into other sports. Hence BAU acquires authentic brands e.g. Maverik (lacrosse), Combat Sports (baseball and softball bats), Cascade Helmets. They then leverage their technology, marketing and distribution platform across all brands and sports.

Steady state, we think the company can grow 5-6% organically (hockey participation rates, superior lacrosse market growth, new product launches, market share gains) while also adding 5-7% through internally financed M&A resulting in double digit revenue CAGRs.

MARGINS
BAU gross margins are 38-40% with EBITDA margins of 14-15%. They don't have accurate comps (some are present in the retail channels; others do apparel and clothing.). The gross margins are in line with the industry and the EBITDA margins are towards the top end, impressive given BAU's smaller scale vs. some of the larger peers. Gross margins fluctuate based on product mix (lower margin hockey stick sales vs higher margin skates for instance). Between 2008 and 2012, gross margins were steady between 38.0% and 40.2% besides 2009 when margins dipped to 35.3%.

The positive margin leverage at the EBITDA level comes from SG&A leverage. Incremental margins have been in the 20% range vs current EBITDA margins of 15% as they can leverage SG&A and there is no reason why this should not continue.

CAPITAL ALLOCATION
Capital is likely to continue to be allocated towards acquiring niche sports equipment makers. Hence an analysis of the M&A returns is important for the investment case. Unfortunately we do not have much history. BAU has completed four deals since becoming public in 2010, only one of which is truly sizeable (Cascade Helmets for $64m).

For what it's worth, we think management teams that have operated under private equity ownership (in this case KKR) and own large stakes in the business (in this case 11%) typically have good capital allocation imbedded in their management style with a focus on ROIC and an awareness of the opportunity cost from alternative uses of capital. In addition, KKR still owns 26% of the company but their intentions are unknown.

BALANCE SHEET
Company reduced leverage from 3.4x net debt / EBITDA in 2010 to 2.5x currently. This is not an onerous leverage level for a relatively stable cash producing business like BAU. Particularly as BAU has counter cyclical cash flows due to high working capital levels. BAU can internally finance acquisition growth in the mid-single digit range, paying 10x EBITDA for acquisition targets while continuing to improve leverage ratios.

FREE CASH FLOW
BAU has high steady state FCF conversion (over 100% of earnings) due to lower cash taxes as a result from deductible intangibles. High working capital requirement drags on cash generation while growing (working capital is 36% of revenues). Low capex intensity (1.4% of revenues vs. teen EBITDA margin).

VALUATION
Absolute valuation, BAU trades on 11.8x current earnings and 9.8x 1yr forward earnings. The company can compound at mid-teens %. In addition, we think the quality of the business deserves at least a market multiple of 14-15x PE. Growth and re-rating give 20-25% IRRs over 3-4 years (higher if re-rating happens sooner).

Our PE target of 14x implies a 10-11x EBITDA multiple which would bring Bauer's valuation in-line with peers not trading with significant growth premia (Under Armour) or on depressed levels profitability (Black Diamond). In a sale of the company, BAU would fetch significantly more than the current 2014 8.4x (EBITDA - capex) multiple.

RISKS
1. Current ice hockey equipment market weakness.
2. Canadian retail concentration.

OTHER
KKR still owns 26% of company on diluted basis. Management incentives aligned with investors (insider ownership 11% - through options rather than shares), Free float 62%