Those of you who have read my previous posts know that I have not had a whole lot of luck looking at stocks in the Canadian market as of late. I decided to expand my search into the USA. My first write up is on McRae Industries (McRae). McRae Industries has a market cap of US$84M.
I will note right off the bat that McRae trades on the pink sheets in the USA under the ticker MCRAA, which means it does not file financial statements with the SEC. The company has not filed with the SEC since 2005 when it ceased doing so in an effort to reduce costs. McRae still posts audited financial statements with Grant Thornton being its auditor for the past 10+ years.
Mcae Industries imports and sells western and work boots, as well as manufactures and sells military combat boots. The key point of distinction being that McRae manufactures military boots, while the company designs and imports western and work boots leaving the manufacturing to a third party. McRae was founded in 1959 and is most well known for its Dan Post brand of boots. McRae is headquartered in Mt Gilead North Carolina which is about a 1.5 hr drive from Charlotte.
Previous blogosphere write-ups on McRae include one at OTC adventures and another at Oddball Stocks. I think this post will add to the conversation by providing more detail around potential growth and valuation.
Let’s put McRae through my screen of: 1) Capable management teams and board, 2) Strong balance sheet, 3) Profitable growth, and 4) An attractive valuation.
1) Management and Board
McRae has two classes of shares. Class A shares elect two directors as a separate class while Class B shares elect 5 directors. On all other matter, Class A shares get 1 vote and class B shares get 10 votes.
As mentioned above, McRae no longer files with the SEC meaning we no longer get share ownership data. As of McRae’s last filing date in 2005, the McRae family owned 40% of Class A shares and 60% of class B shares and controlled 53% of all votes.
For the same reason (ie. McRae not filing with the SEC), we do not currently have data on executive pay. In 2005, Gary McRae (President) was paid ~$250K while the four named executives were paid a cumulative ~$800K.
I assume that the McRae’s have maintained their ownership, while it is likely that pay has increased as net income has increased.
My view is that the McRae family communicates with shareholders in an open and candid manner. This boosts my confidence in the quality of the management team. One example is how Gary McRae has communicated about trends related to Western boot sales. The excerpt below is from the 2014 annual letter which came before Western boot sales peaked in 2015:
“We see our western/lifestyle segment in a state of change. The women fashion consumers who have driven the market in this business over the past few years are becoming more price conscious. Because of this, we see more of these consumers moving from the Dan Post brand to the popular priced Laredo brand boots. We will be introducing our new line of men’s, women’s and children boots at the Denver WESA show in January 2015 and are excited about the designs we have to offer. To some extent, we expect the revenues in this segment to be down from previous years as the market adjusts to these changing boot preferences.”
Gary McRae literally warned shareholders of an upcoming challenging environment. This is unheard of in today’s era of fast-talking, free-wheeling management teams. Most management teams keep problems hidden until they get so ugly they can no longer be disguised. This is similar to a teenager with an enormous pimple. When the pimple first appears and is small, the teen has no shame in using a bit of cover-up to hide it. But at some point the pimple get so friggin’ huge, that the teen admits defeat and exposes it to the world as any more cover-up would make their face more orange than Donald Trump’s.
In short, McRae communicates with their shareholders like they are partners. For this reason, they have gained my trust and a vote of confidence.
2) Balance Sheet
Some may call it “overcapitalized” or “lazy”, but to me, McRae’s balance sheet is pristine. Similar to a ski mountain early in the morning before first tracks have been made, McRae’s balance sheet has not been disturbed by anyone. No banker or anyone even acquainted with a banker has made their way near this balance sheet.
McRae has a relatively small market capitalization having grown from ~$30M 10 years ago to ~$84M today. Despite this small market cap of $84M, McRae has nearly always maintained a double digit net cash balance.
Astute readers will notice the large ramp in cash between 2016 and 2017. A natural question is what caused the cash increase and will it be permanent.
The chart above makes it clear the surge in cash was due to a large reduction in working capital. Cash flow before changes in working capital (blue line) has remained relatively stable, while cash flow after changes in working capital (red line) has surged. In the case of McRae, the specific reason is a reduction in inventory. A large portion is due to a reduction in military inventories. I expect this to be sustained as military sales are now on the decline. This could change if McRae wins new military contracts.
3) Profitable Growth
In the chart below, you can see the top line (purple) has flattened out over the past four years. This is largely due to sales in the Western category (blue line). An offset has been military (green line).
Although it does not show up in the chart below, Military sales are currently rolling over hard as the company has yet to fill lapses in old contracts with new contracts. Military is on pace in to be down ~45% y/y in FY18 (y/e August). To put this in context, Military sales could fall from their level of $46M in FY17 to ~$25M in FY18 if McRae does not announce new contract wins.
My expectation would be that McRae will continue to win new military contracts, although overall levels could continue to be lumpy as we are currently seeing. I say this because of the nature of government contracting. The government has legislated that 23% of all government contracting dollars should be awarded to small businesses. McRae qualifies as a small business as it has less than 500 employees. Further, McRae has an even further advantage as some of its manufacturing capacity is located in a ‘HUB’ zone (historically underutilized business zone).
On Western, the trend in segment sales looks bad. However, numbers need to be viewed in the context of a broader narrative. I would be concerned if McRae sales were down while the rest of the industry were flat or gaining (ie. McRae was losing market share). In order to find out if this is the case, the next step is to figure out who McRae’s competitors are and their respective sales trends.
McRae’s largest competitor is the company that owns Justin and Tony Lama boots. This company happens to be Berkshire Hathaway. Given the boots are a very small part of the much larger conglomerate, disclosure is non-existent.
McRae has another competitor that is a public company named Rocky Brands (NASDAQ:RCKY). Rocky is a much better comparison because similar to McRae, it only produces boots. There is a slight difference in that the majority of Rocky’s sales come from work boots ($110M) and Western Footwear is a secondary category ($39M of sales). Rocky also has a significant military business $38M of sales).
As mentioned above, I would be concerned about McRae’s competitive position if they were shrinking in their sales while their competitors gained. The chart bellows show McRae’s Western sales (Blue line), relative to Rocky’s (red line).
McRae rose faster than Rocky’s, but it has also shrunk quicker. I attribute this to McRae, or more accurately Dan Post, having a stronger brand in the marketplace than Rocky’s Durango brand.
One reason I say this is due to the trend of Durango’s high and low price points over time (available in 10-K).
In the chart, you can see that Durango experimented with a high price product line (red), but it failed and prices were quickly restored back to near previous levels. On the other hand, the low end of Durango’s product line (Blue) has continually seen price reductions.
Western Boots went through a boom between 2012 and 2014. During a boom, consumers are less price sensitive and more sensitive to brand and style. When consumers placed a higher weight on brand and style, McRae won relative to Rocky (as averaged in McRae’s higher level of sales between 2012 and 2014). However, as the fashion trend has subsided, consumers have become more price sensitive and have weighted cost as a higher factor in their purchase decision. Since McRae gained more during these boom times, they have lost more as consumers’ tighten their purse strings.
In summary, I do not think McRae has any structural impairment around their Western segment. I also think Military sales will eventually rebound with new contract wins. Overall, McRae is in a mature category, and I expect this to be the major determinant of their growth in the future. Sales will likely stop declining, but it is unlikely they exceed the low-single digit (LSD) to mid-single digit (MSD) range.
One last thing to note is Boot Barn (a major retailer of Western boots) recently reported a quarter with MSD same-store sales growth for the first time since mid-2015 (note the fiscal year is ended April 1). Boot Barn had been struggling to overcome the impact of the oil price collapse in late 2014. This reversal could bode well for McRae’s future Western sales trends. Given McRae is the manufacturer and Boot Barn is the retailer, it is logical that Boot Barn’s sales would turn up before McRae’s as Boot Barn is closer to the final customer. In McRae’s most recently reported quarter (Q1/FY18), Western boot sales were down 8%.
The judgement of valuation is often in the eyes of the beholder. Some will say timing the market is impossible, so why bother? Stocks return the most of any asset class over the very long-term, so you should always own them. If you believe this, then it follows that in picking individual stocks, it should only matter if one stock is “cheaper” relative to other similar stocks. Valuation in an absolute sense is not important. Or in other words, stock selection becomes a relative valuation game.
On the other hand, you may think that we are 10 years into a bull market so a stock’s valuation relative to its history is important. For the most part, all stocks are expensive relative to history, so why be invested? Valuations revert to the mean over long periods of time so there will be a better time to buy. You are willing to participate in the market but only in exceptional circumstances when you find shares that are both undervalued relative to peers, but also undervalued to where they have traded historically.
I do not wish to delve further into this argument and pass judgement as to which side is right in this post. However, I do help to provide perspective on both sides of the argument.
First let’s look at McRae’s valuation relative to history. The way to read the charts is that each year has a line with a dot. The top of each line represents the high in valuation for the year, the bottom of the line represents the low and the dot is the average valuation for the year. The green dot is where McRae currently stands based on my estimates for FY18. I have looked at this analysis for P/E ratio, EV/EBIT, and P/B. In short, each metric suggests McRae is near the high end of its valuation range relative to where it has traded historically.
So in an absolute sense, McRae looks expensive. The other way to think about valuation is how McRae trades relative to other public companies. As mentioned above, Rocky Brands is a close competitor so we can look at how the market is valuing McRae relative to Rocky.
On both a P/E and P/B basis, McRae looks to be priced at a similar level to Rocky. However, on an EV/EBIT basis, McRae is at a significant discount to Rocky. This is very interesting in my opinion. Both P/E and P/B ratios have share price in the numerator. This means that McRae does not get any credit for its large cash balance when using these ratios. On the other hand, EV/EBIT does give credit to McRae for its cash balance (see Appendix 1 if you need an explanation why).
This divergence in valuation metrics suggests to me that the market is taking the view that the cash within McRae is “trapped” because of the family ownership, and therefore should not have any value attached to it. This to me is short sighted. Cash has strategic value during recessions when financing is hard to come by and there are forced sellers in the market place.
The McRae family appears to be honest and competent operators; I am happy to be their partner. McRae has a very strong balance sheet; a point the market appears to be overlooking in its valuation of McRae relative to Rocky. While McRae’s Western business has been weak and Military business is expected to be weak over the coming year, I do not think either business is structurally impaired. McRae should be able to grow with the market at a minimum over the long-term.
Appendix 1: Industry Analysis
When first becoming acquainted with an industry I find it helpful to draw out a value chain of the different players involved in getting the final product to the end-consumer.
Some value chains do not have any excess profits associated with them. Others see the excess profits migrate to the single step in the chain that has the most power. In terms of Western boots, my opinion is that the designers and brand owners (ie. McRae, Rocky, Justin, Tony Lama) have the strongest position. An outline of strengths/weaknesses in each step follows:
Raw materials: Historically a very tough business. Most profits are earned during periods of short supply, but these do not last long as new capacity comes along and excess profits get competed away. Major raw materials are leather and rubber.
Contract Manufacturer: While reputation and reliability count for something, the premium that a contract manufacturer can earn will always be limited. McRae can do product tear-downs and will be able to know what a product should cost to manufacture. McRae’s business will be put out to bid with multiple contractors competing. McRae will always experiment with new sources of supply so that it can never be held captive by a single contract manufacturer.
Designer and Brand owner: This step of the value chain is relatively light on capital as the major investment is inventory. In order for the brand to remain relevant, the company must keep styles current and support the brand with marketing spend.
Retailers: According to Boot Barn (NYSE:BOOT), there are thousands of independent specialty stores across the United States that sell Western boots. Boot Barn is relatively small with 219 stores, yet they think they are 3x larger than their nearest competitor. This high level of fragmentation is advantageous to McRae and other manufacturers. Most of the manufacturers’ customers lack the scale necessary to backward integrate into brand ownership and manufacturing. This limits their ability to demand volume discounts and advertising support when bargaining.
A conversation about industry would not be complete without discussing the impact of technology. As consumers change their purchasing habits from on premise to online, there is risk that a dominant internet retailer of Western boots could emerge, develop its own brands and cut out brand owners by going direct to the contract manufacturers. In this case the new value chain would have one less step and look like this:
To some extent, Boot Barn is trying to do this with its growth strategy which includes both 1) increasing private label penetration from the current 11% of sales level, and 2) increasing sales done via e-commerce (demonstrated by their acquisition of Sheplers). There is not an immediate threat to McRae because Boot Barn still relies heavily on brand owners for logistics capabilities. Most of Boot Barn’s merchandise is delivered directly to their stores and they need brand owners for this capability. I’d also note McRae is positioned to benefit from private label as they exclusively supply Boot Barn with their El Dorado brand. More recently, Boot Barn announced “exotic” extensions to their El Dorado brand:
Given the importance of proper footwear fit, I view it as unlikely that a new brand will be able to emerge out of an online retailer. I view online purchases to be more likely from a brand that the customer is already very familiar with. For example, if they have a favorite boot and the sole has worn out, it will be easier to reorder the exact same boot at the exact same size online.
I’d also note that ‘authenticity’ is an especially important trait of Western boot brands. Dan Post for example is “Cowboy Certified”. Boot Barn’s motto is “Be True”. It is difficult for an upstart to have the same authenticity as a brand that has successfully appealed to American outback values for several years. This can be seen by the simple fact that there are not many new Western boot brands. The last major brand to emerge was Ariat in the early 1990s. They did so by competing at the high end, and focusing on first appealing to athletes competing in horse riding. Other Western brands and their inception date are listed below:
Dan Post – Mid-1960s
Durango – 1968
Tony Lama – 1911
Lucchese – 1883
Justin Boots – 1879
Stetson – 1865
The support for McRae having a strong position in the value chain comes from McRae having better return on capital than Boot Barn (their customer).
McRae also has better numbers than Rocky, its closest publicly traded comparable. A higher ROIC versus a competitor generally implies the company with a higher ROIC has a competitive advantage. They are able to do something that their competitor cannot. If their competitor could replicate their efforts, they would earn similar returns on capital. In McRae’s case, I think the higher ROIC is a result of a stronger brand.
While it looks like McRae has a lower gross margin, it is being weighed down by military having a very low gross margin of only ~15% and McRae having a higher mix of military sales than Rocky. McRae’s Western boots carry a gross margin of 34% and work boots have a gross margin of 35%. This is relative to the gross margin in Rocky’s whole sale segment of 32%. McRae having a larger gross margin than Rocky is consistent with McRae having higher prices points implying a larger brand premium. This difference in gross margin largely falls down through to a difference in EBIT margin. I’d also note McRae’s pre-tax ROIC number is helped by carrying less inventory on its balance sheet than Rocky.
Out of interest, I took a look at the numbers for a similar, but adjacent value chain. The numbers for Nike (NKE), Foot Locker (FL) and Finish Line (FINL) are below. My main takeaway is that one of the reasons the numbers for the athletic shoe value chain are so much higher is that the chain turns inventory much quicker than the Western boot chain. Players in the athletic shoe chain turn inventory 4x a year versus 2x a year for the Western boot chain. Nike has also done a good job at building its brand and extracts a price premium from the consumer which shows up in the gross margin line.
Appendix 2: Enterprise Value (EV)
Enterprise value (EV) is defined as market capitalization (share price * shares o/s) plus net debt (total debt less total cash). Let’s use an example to illustrate. The company has: 1) 10 million shares, 2) a share price of $10, 3) Debt of $20M, and 4) cash of $10M. In this case, the company’s market capitalization is $100 million (10 million shares o/s * share price of $10). Net debt is calculated as $10 million (total debt of $20 million less $10 million of cash). So enterprise value is $110 million (market capitalization of $100 million + net debt of $10 million).
In McRae’s case, there is no debt and a large cash position, so the calculation becomes market capitalization minus net cash (rather than plus net debt). In the example above, let’s now assume $20 million of cash and $10 million of debt. So net debt would be -$10 million and EV would be $90 million (100 million market capitalization less the $10 million net cash position).
The Company’s website: www.mcraeindustries.com/
Author Ownership: YES OTCMKTS: MCRAA
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