Thursday, June 18, 2009

Arctic Cat: Is this a SCREAMING DEAL or not?

Arctic Cat manufactures snowmobiles and all-terrain vehicles (ATVs) and sells related parts, garments and accessories. The company was formed in 1983 as a snowmobile manufacturer.

In 1995, the company entered the fast-growing market of ATVs. Because it had already established its brand among snowmobile customers, it was logical to cross-sell them and offer ATVs. In 1996, only 3 percent of revenue came from ATV sales. By 2007, 55 percent of revenues came from ATVs and only 32 percent came from snowmobiles. From the time that Arctic Cat entered the ATV market, its sales grew faster than the industry's. Based on several conversations with dealers of Arctic Cat, some of the reasons for Arctic Cat's success in the ATV business are:

  • brand loyalty from the snowmobile clients
  • superior suspension system
  • high durability
  • faster response time for customer demand as a result of the company's smaller size
  • innovation where competitors, such as Honda, are too complacent

Arctic Cat has a better brand name in the snowmobile market and faces fewer competitors (Polaris, Yamaha, and Bombardier) than in the ATV market (Polaris, Honda, Yamaha, Kawasaki, Suzuki, and Bombardier).

Its stock is extremely attractive because of the trading price. As of the date of this posting, the market capitalization (total # shares x price per share) for the entire company was approximately $70 million. Its inventory cost the company more than the price tag of the entire company. But some might argue that the inventory value is declining because fewer customers are buying snowmobiles and ATVs in this economy. While this is true, it does not mean that the stock is not a good deal.

Let's say we want to get into the business of manufacturing snowmobiles and ATVs because we believe that eventually the economy will be better than it is today. What things do we need to start? Besides technical knowledge, we would need a factory, equipment, tools, raw materials (inventory), etc. These are all the things that are listed on Arctic Cat's balance sheet. Let's say we spend a total of $100 million, of which $50 million is spent on inventory and the other $50 million on equipment, tools, and a factory. Would it make any sense for us to say, "Well, we are losing money this year so we will sell it all for $25 million, which is half of what we spent on inventory?" Clearly, it would not make any sense, but this is what Arctic Cat is selling for.

But even if we could produce these snowmobiles and ATVs, how are we going to sell them? Most of these products are sold by dealers and trying to convince them to carry our product would not be easy. Without an established brand name, building a network of dealers is extremely hard and it would take a significant amount of time and money. The Arctic Cat brand has been around for 45 years, and the company established itself as a leader in snowmobiles and a significant player in the ATV business.

The company already has a strong dealer network. It is not hard to see that its brand name and dealer network are assets to a company such as Arctic Cat. Since they are assets, they must be included on the balance sheet, right? Actually, they are not, even though they probably are worth more than any single item listed on the balance sheet. A balance sheet mainly includes historical costs such as inventory, equipment, and properties. Arctic Cat did not purchase its brand or its dealer network but built both by promoting and advertising over many years. Promotion and advertising are expensed as incurred, and they flow through the income statement and do not create an asset. The only way for Arctic Cat's brand and dealer network to appear on the balance sheet would be when an outside company such as Polaris or Kawasaki purchases the company outright. Then, all the tangible assets such as inventory, equipment, and property would be recorded on the acquirer's balance sheet and the difference between the purcahse price and tangible assets would be recorded as goodwill.

Even if the brand and dealer network were worthless, buying the stock of Arctic Cat is still below net working capital (current assets - current liabilities). Anybody buying Arctic Cat outright could liquidate the company by selling inventory, equipment, and properties and still end up with more money than the $75.5 million dollar price tag.

So, why is the stock so cheap? As a start, Arctic Cat is bleeding cash. Because the economy is weak, people tend to postpone purchases of discretionary items such as snowmobiles and ATVs. Also according to the article "Thin Ice at Arctic Cat" by Dee DePass (, some institutional holders bailed out, selling 12 million shares on the market. Keep in mind that there are only about 18 million shares outstanding and Arctic Cat's stock does not trade on huge volume. Imagine what can happen to the price of a stock when 66 percent of shares are being sold. Driving the price to the current levels is beyond logic. Professional money managers are people and just like individual investors, when the fear of losing money is present, logic goes out the window. The good news is that when the stock is purchased before some of the institutional investors return as the economy improves, the stock price has a chance to take off like a rocket.

But since the company is losing money, it can go bankrupt, right? What is the requirement for a company to go bankrupt? It first must have debt, and Arctic Cat has no debt. Arctic Cat learned its lesson in 1981 when it went bankrupt after lenders called all the loans due. The original founder and some key managers went to the auction and bought up the company in pieces and started Arctco, which later became Arctic Cat.

Even though Arctic Cat has no debt, it is still losing money because of large fixed expenses associated with the manufacturing business. To preserve cash, the company already suspended share buybacks and divideds. From my estimation, the company will lose anywhere from $30 to $50 million in 2010, and it does not have enough cash on hand to weather this situation. But just because the company is losing money does not mean that the stock price will drop more or is not a good buy. As of this posting, the market knows the company will continue to lose money, so this information is already priced into the stock.

The bottom line is this - Arctic Cat will have to get the cash to cover the shortfall. Some market participants are worried that Arctic Cat will not be able to raise any cash because no one will want to lend them money. I have a different view. If the company cannot secure any conventional financing, it still has many options. First, it can get an asset-based loan against accounts receivable and inventory. Second, the company owns some real estate: manufacturing/corporate office (558,000 square feet), distribution center (220,000 square feet), test & development facility (3,000 square feet), and manufacturing facility (60,800 square feet). Many investors overlook real estate. Having experience in commercial real estate, I know that Arctic Cat could easily sell these facilities to raise cash and lease them back from the buyer. This is called a sale-leaseback transaction. Third, even if all of the above fail, the company may sell itself to the bigger players such as Polaris, Kawasaki, Suzuki, etc. All of these players would love to acquire the brand name of Arctic Cat.

Last time I invested in a similar situation where financing was in question, I more than quadrupled my money. The company was called Teck Resources (TCK), and I bought it for $3.32 and sold it for $14.35.

Arctic Cat is a great company with a recognizable brand name. Currently it is going through tough times due to the economic recession. Patient investors might find the stock to be attractively priced. But before investing in the company do you own research and consult your financial advisor.

Disclosure: I, or persons whose accounts I manage, own shares of Arctic Cat at the time of this posting.