Brunswick Corp.’s earnings outlook is "much more stable than investors may perceive, suggesting compelling risk/reward," according to a note published this morning by RBC Capital Markets addressing "misconceptions" about the company.
Although demand for new boats is expected to be flat through 2012, a “re-framing” of Brunswick’s business demonstrates why it can be a good stock, even without a near-term industry recovery, according to analyst Edward Aaron.
By focusing less on Brunswick's boat division and more on its profit pools, investors can better appreciate why: 1) An industry mix shift toward smaller boats isn't bad for Brunswick; and 2) Brunswick's business is far less cyclical than in the past, the report said. Also, the boating market is unlikely to contract much more.
The company’s bowling, commercial fitness and marine parts and accessories businesses “should be valued more highly,” Aaron wrote.
“It’s easy to shun the stock on the basis that no one is going to buy a boat in this economy. But we view this statement as an oversimplification and misses some key aspects and important nuances of the business,” he noted. “We find that putting some context around Brunswick’s business leads to a more constructive view of [Brunswick] shares than what the market is currently discounting. To be clear, we are not suggesting that [Brunswick] is somehow immune to economic risk. [Brunswick] is and will likely always be a high beta stock. Rather, we are simply suggesting that investors are overstating Brunswick’s cyclical earnings risk.”
Although a recovery in the boating industry may be down the road, “demand is unlikely to cause a double dip in the boating cycle, given the dramatically reduced base of industry sales. We believe a flattish industry demand scenario is an appropriate base case looking out to 2012.”
With demand of roughly 140,000 units, down nearly 50 percent from the 2005 peak, the boating industry is hovering near all-time lows. A historically low mix of new versus used sales and an aged fleet of registered boats should keep a floor under demand, according to Aaron.
New boat sales account for about 15 percent of total industry sales, and the average registered boat now stands at 21 years, compared with 16 years in the late 1990s, per Brunswick’s internal data.
“If our view holds, boating industry dynamics in 2012 would likely look much like 2011 — i.e., flat demand, small boats outperforming large boats and Brunswick taking share. Longer-term, it seems reasonable to expect that the cycle will become more of a tailwind,” he said.
Therefore, it’s time to de-emphasize the boat business.
“We would go so far as to argue that the boat business should no longer be the basis for either buying or selling [Brunswick] stock. This might seem like a paradoxical statement, but given its relative profit potential, the fact of the matter is that the value of Brunswick’s boat business is simply not proportionate to its 27 percent contribution to total company revenue base, and we don’t see this changing anytime soon,” Aaron wrote.
“In terms of fundamentals, we do not think the boat business is the best part of Brunswick. It’s a low barrier-to-entry business with limited scale opportunity. These factors help explain the surprisingly low failure rate among boatbuilders through the downturn and the comparatively slow profit recovery of this division,” according to the report. “Given the company’s relative brand strength and common platform manufacturing capabilities, Brunswick’s boat business is advantaged versus its competitors. But these benefits can only take the boat business so far in a lackluster demand environment.”
He predicted a high probability that Brunswick’s boat division will become neutral to the company’s earnings within a couple of years.
“In speaking with management, it seems clear to us that the senior leadership of Brunswick has a clearly defined plan to return this business to at least break-even within a reasonable period of time without the help of an industry recovery,” Aaron said. “The boat business might ultimately have some upside profit opportunity, but at this point we just don’t think it’s prudent to count on it.”
The overwhelming majority of Brunswick’s earnings and value lies in the engine and fitness divisions that, in contrast to boats, are good businesses. Both businesses have high barriers to entry and reward good technology and innovation. Brunswick also holds dominant market positions in each of these businesses.
“In a ‘risk off’ tape, there might not be much be urgency to buy a stock like [Brunswick]. And frankly, we do believe that [Brunswick] shares are more appropriate for investors with longer time horizons,” Aaron wrote. “Still, it’s worth noting that we’re approaching a part of the year that historically is very kind to this stock. Brunswick has a long history of outperforming during the offseason months and underperforming during the actual selling season.
“The stock usually starts to work in [the fourth quarter] because the risk of disappointment is low and [the first quarter] is usually exceptionally strong as optimism of the boating cycle builds. After all, do investors ever feel incrementally worse about the upcoming selling season after going to the Miami Boat Show?”