Opportunities at Escalade
Capitalizing on niche sports going mainstream
Escalade (Nasdaq: ESCA - $170 million) is a niche sporting goods company producing equipment for archery, billiards, table tennis, basketball hoops, watersports, tailgating sports, and more. It has a dominant market share across its primary niches including the rapidly growing pickleball market in the United States and has one of the most transparent management teams I’ve seen from a public company in regards to capital allocation and execution on business plans.
With the opportunity to quickly pay down its debt and continued organic growth, I believe Escalade’s stock is highly undervalued. My view is that the market has incorrectly de-rated Escalade alongside other smaller sporting goods companies and that there is almost 100% upside on the stock (as of the time of writing on May 11th).
From Niche to Mainstream
While Escalade has a dominant market share in several key categories such as in-ground basketball hoops, billiards, table tennis (they own the “ping pong” trademark), and darts, Escalade’s position in the rapidly growing pickleball market is one that I find particularly exciting. As Patrick Griffin, the VP of Corporate Development and owner of over 13% of the stock told me in our conversation:
Pickleball is like the 1840’s California Gold Rush (Patrick Griffin)
With Pickleball being the fastest growing sport in America, growing 39% since 2020 to a player count of over 4.8 million (over 1/4 of that of tennis), I would say that statement is accurate. The surge in people playing the sport is driven by meaningful tailwinds. These include
Age Demographics: Players skew older, and America is an aging country (though the fastest % growth in players is among younger cohorts)
Cost & Size: Pickleball courts are smaller and much cheaper to build/install than tennis and other sports, and tennis courts can easily be converted.
Moving Trends: Domestic migration is towards areas that are warmer for longer portions of the year (cc 2020 census) which is beneficial for outdoor sports, as is the shift to suburbanization seen since the pandemic
Ease of Play: The game is simple to play, relies on reaction time over intensive cardio, and has shorter game lengths, increasing the potential player base
A combination of these factors has led to a surge in growth that search trend data shows has been accelerating and not facing a “mean-reversion” like many outdoor-related activities have in the past year. While it doesn’t have a “star player” to the public yet, it’s begun to rapidly grow as a spectator sport and is just shy of having the seventy-five member nations required to make a bid to be included in the Olympics.
Escalade has been able to capitalize on the Pickleball boom because of its early entry into the space. Through its acquisition of Onix in 2015, the company has grown to have the highest market share out of any pickleball equipment producers for its paddles and balls. It’s even the official ball of the Professional Pickleball Association and its tour events.
Using comparisons to tennis’s domestic wholesale numbers and estimating Escalade’s market share at 35%, I estimate that Escalade generated $34 million in wholesale revenue with Pickleball equipment in 2021. With 35% of its sales coming from online channels, my total pickleball sales estimate for Escalade in 2021 is $52.3 million, or 16.67% of sales as the sport is now more searched for than other key portions of the business such as archery and billiards.
Considering the sales multiple they’ve paid for other acquisitions and the growth observed in the sport’s size since 2015, this is a number I have high confidence in. Pickleball products are margin accretive to the business and should continue to grow as a share of Escalade’s sales despite the recent acquisition of Brunswick which has an annual sales rate of over $25 million.
These are all positive signs, but it’s important to find the distinction between growth in an industry versus the ability of a producer to capitalize. A key risk, especially for a smaller business, would be that larger sports equipment producers commoditize the space and eat up share, or that the company’s lack of relative capitalization inhibits its ability to effectively scale and it loses out over time. My professor (a former portfolio manager), shared with me the story of a snowboarding stock that had a leading market share but couldn’t compete as big companies entered the space in the 1980s as the sport blew up, leading to its failure. With major brands like Franklin betting on the pickleball market and getting deals (inked a contract to be the official ball of the USA Pickleball Association), this is worth evaluating.
Escalade is larger than Franklin when it comes to annual sales for each business. However, Wilson Sporting Goods is a larger peer that is entering the pickleball vertical, as is Prince Sports (Asics has only introduced paddle-sport shoes). There are also a large amount of smaller competitors all competing for share in this market, in part because there are low barriers to entry for producers. Despite the deluge of competition from better-capitalized firms and smaller peers, Escalade has managed to grow its market share in the pickleball market in the past year.
This is in part due to good business execution on inventory investments to have supply on-hand for customers when other companies couldn’t (they aim to keep this gained share and grow it out), as well as brand investment and sponsorships, which the business views as vital to succeeding. Escalade’s decentralized organizational structure has also benefited the company can be nimbler in its decision-making process and has a better ability to move alongside changes in the customer. In regard to scaling, the company has been investing in expanding capacity across the business and has additional room to expand at its owned facilities. With this, I have reason to believe Escalade will remain the market leader for pickleball equipment as consolidation eventually takes place in the industry.
Unique Execution and Allocation
The growth in pickleball is promising for Escalade, but the company’s transparency in regard to capital allocation, strategic decisions, viewpoint on creating shareholder value, and willingness to admit when they have not operated to expectations are what sold me on this business. I will cover some points but highly recommend reading the past three shareholder letters by the current CEO here.
Take the introduction to the shareholder letter discussing 2019’s results for example
Fellow Shareholders, Escalade’s financial performance in 2019 was very disappointing. These results are unacceptable for any healthy business, even more so for a company like Escalade that has strong brands and leading market positions in stable categories. While some of the low level of profitability can be attributed to investments in new businesses that should pay off in the future, the fact remains that our company did not perform anywhere close to its potential or to the level that you should expect from us. (Escalade Shareholder Letter)
Such a candid admittance of not meeting expectations is incredibly rare for management teams of public companies to give to the public in such a manner. Escalade doing so shows a unique commitment to the shareholders of the business. that is the backbone of the company’s decision-making process which has led to impactful benefits.
For example, the company chose to maintain domestic manufacturing while competitors moved almost fully offshore. The company actually doubled down on domestic investments, increasing its primary distribution center’s size by 20% and acquiring a leased facility to avoid rising rents. With ongoing supply chain issues, this has enabled the company to fill inventory for customers when competitors could not, taking material market share across its categories as a result.
The company’s perspective on being aligned with shareholders is also unique from that of a public company where management teams tend to forget far too often that they are stewards of other peoples’ capital.
We also believe it's critical that the interests of the company, the board, and the management team are aligned with our shareholders. We think one of the best ways to achieve this alignment is to have officers and directors who hold a significant equity position in Escalade. To that end, our officers and directors' ownership represents over 20% of the shares outstanding. (Escalade Q1 Conference Call)
This alignment with shareholders is something I can ascertain to be real from experience. I’ve sent inquiries to many companies over the past year, most of the time getting no response or hear there is a quiet period so nothing can be answered (even though earnings just happened in instances). Escalade is different. I got a response the same day asking for times I was available in the next week. The company chose the soonest available time to meet with me and had an over 30-minute phone call with me despite my ownership stake being 0.0007%.
This alignment with shareholder interests is one that is leading to strong capital allocation decisions. These come in the following sets for the company right now
Inventory: Primary investment last year leading to market share gains
Debt Reduction: Current primary objective, company explicitly mentions EV swing in their reasoning for this
Reinvestment: Previously discussed domestic production expansions and re-launching of owned e-commerce sites which the company believes can grow to over 10% of sales over time
Returning to Shareholders: Uses dividends and buybacks, has paid a quarterly dividend for 10 years (current forward yield is 4.79%) and bought back over 8% of shares in the past three years
Outside of these methods, the company is also a serial tuck-in acquirer and will often use acquisitions to enter new industries. The company entered pickleball in this manner and has done the same more recently with watersports through its acquisition of Rave Sports which it acquired in 2020. The company will be scrappy and likes to buy assets out of bankruptcy as it did with American Heritage Billiards in 2020. It has also shown a willingness to solidify its position across verticals within a segment, as securing the high-end billiard market was a driver in acquiring Brunswick Billiards earlier this year. This particular acquisition cemented dominance within the billiards niche as they now own the highest market share brands across entry, intermediate, and high-end billiard tables and cues.
As part of my research, I had conversations with both Patrick Griffin as mentioned earlier, but also with some of the largest shareholders that are not affiliated with the company. I pressed both on the dividend policy in particular, since my concern with capital allocation in this regard was the potential for the insiders who own over 33% of the company to be using this as a way to pocket money rather than focusing on the long-run health of the business. My conclusion was that my concern was not warranted. Furthermore, dividends do have the benefit of immediate cash flows versus buybacks betting on the future. While I like both when they’re applied correctly by a company, the certainty of cash flows today is a particular benefit.
The last point I’ll highlight (I could go on for far longer but word count matters), is the company specifically acknowledged to me in my conversation that they’re fighting for people’s time and attention. Considering the digitalization of the 21st century and every leisure item having to in some way compete for the time or attention of customers, I found this to be a qualitative note on the company’s outlook that is particularly positive. The company knows digitalization is a trend but views itself as a company that “sells fun” and views itself as providing a way to connect offline, something I believe will remain relevant despite the hopes some people have for a metaverse.
Overall, the unique transparency of the current management team is something I find extremely attractive and is an important qualitative factor regarding Escalade. The execution of this team has not only led to competitive advantages in manufacturing and sourcing but has also enabled the company to become dominant in niches it had no prior exposure to. This has been done while making divestitures when necessary and with a priority of increasing shareholder value. When combined with the company’s growth opportunities, I’m optimistic about the company’s outlook.
There’s much more I could say. However, even without any reader having any interest in buying this stock (I’m not here to sell this to you just share my passion for learning), I’d implore anyone serious about investing to read these shareholder letters. From my experience, though limited, the will to put this detail out to every investor so easily is rare. You can read here
So, the company’s position in its key niches is solid, its place in a rapidly growing segment has gotten stronger, and the execution from those in charge of the business is uniquely good. That doesn’t matter if the company is fairly valued.
For reference, the company currently trades at 6.85x trailing EV/EBITDA. Other than early 2020 during the Covid market crash, this is the lowest multiple the stock has had since transitioning to a sporting goods only business.
This is somewhat fair considering this is the most debt the company has had in the past decade. However, stocks trade on forward expectations and I believe there is a gap in the market’s understanding of Escalade’s ability to quickly pay down its debt. The company is producing net income at a run-rate of $25 million at the time of writing, and this should grow healthily over time.
Furthermore, the company will unwind its inventory position towards more normal levels which will be very accretive to cash flows over the next two years (possibly in excess of $30 million, though timing will vary). This should allow for a paydown in debt that is stronger than the market is pricing as 2/3 of the company’s debt is on a revolving credit line.
The following are the assumptions for my model’s base case
Total debt is reduced from $100 million to $30 million over the next 11 quarters
Operating cash flow runs at an elevated rate in late 2022 through 2024 as inventory unwinds and normalizes thereafter
Debt level limits acquisitions over the forecast period
Operating margin grows from 10.2% to 11%
Dividend grows at 7% annually
100,000 shares are bought back annually
Sales grow at 11% in 2022, 10% in 2023, and 9% in 2024
This model gives a 2024 EBITDA projection of just over $50 million. Given an EV/EBITDA multiple of 8x (lower bound of late-2018 to mid-2021 valuation range ex covid crash), This gives a price target of $27.85. After factoring in dividends over the next 11 quarters of $1.78, my base case gives a total value of $29.62.
This 136% upside is not my price target, however. This is because I have to learn to think in probabilities. Such a skill is a necessity for me in order to achieve success in any future career that involves research, allocation, and risk management, and I’m using my writing as a vehicle to employ that learning.
Thus, here is my bear case. It assumes the following
Something materially damages consumer demand (inflation, recession), or the company loses market share in major segments (fails to land deals, poor inventory management, loses licenses it currently has)
Sales grow at 5% in 2022, decline by 15% in 2023 and grow by 5% in 2024
Margins don’t recover as inflationary pressures overwhelm the company’s domestic positioning and loss of volume from the sales decline further harms margins, 2024 operating margin is forecast at 5.5%
No buybacks are done and the dividend does not grow
Total debt is only reduced to $52.5 million over the next 11 quarters
These assumptions bring a far lower 2024 EBITDA of $21.16 million, more in line with the company’s mid 2010 levels. In this scenario an EV/EBITDA of 5x is given (matching the low of the valuation range over the past 20 years). This gives a price target of $4.39, or $6.04 after factoring in dividends, a decline in total value of 52%.
My bull case employs a scenario where statements from the first quarterly conference call done by the company regarding growth play out as accurate.
So that all kind of works its way down to kind of low to mid-teens long-term growth rate, that's what we're targeting. (Escalade 2022 Q1 Conference Call)
That statement implies a goal, through organic growth and future acquisitions, to maintain topline growth in the teens. In such a scenario I believe 2024 EBITDA of $61.7 million and further accelerated debt paybacks could be possible. This scenario would give a total value of $46.19, or an upside of 269%.
With these scenarios, the base case is weighted at 60%. The bear case is weighted at 30% due to the more elevated risk of consumer demand issues that have emerged as a concern, though this data has not shown up as a reality in any data yet. The bull case is weighted at 10% and would be a scenario where further acquisitions and debt payback go better than expected and the tidbit about the long-term growth rate is accurate.
The resulting probability-weighted price target for the end of 2024 is $24.20. This represents an upside of 93% from the current closing price and gives an annualized expected return of 28.24%. The bear case has a real chance of occurring at 30%, but on a risk-adjusted basis, the probabilities indicate that Escalade could give strong returns to shareholders.
Due to compliance at my summer internship that begins in two weeks, my deep dives will be on a hiatus until August. I’m incredibly grateful to everyone who reads my rambling and personal learning journey, and I’m aiming to come back in three months with even more knowledge and skills to apply to the writing I put out. I’ve been fortunate enough to meet several amazing people as a result of this newsletter, and I’m incredibly grateful to each person that finds their way to one of these links. You’ll be in good hands with Markets Aurelius in the meantime, and you know I’ll be coming back with something fierce when the time comes. Thank you again and I’m wishing all of you the best.
Disclaimer: I hold 108 shares in Escalade as of the time of writing (May 11th, 2022). I received no compensation to write this article. As the footer states, these are my thoughts alone and should not be used as the basis for an investment decision.