Welcome to Overlooked Alpha by Vince Martin and Joe Marwood. Subscribe below to get our best investing ideas direct to your inbox every Sunday morning:

I’m not much for personal stories driving an investment thesis, but when it comes to boating stocks there are two worth mentioning up front.

Back in the winter of 2008-09, a wealthy and savvy friend of mine decided to look for a boat. Amid a raging financial crisis, it was obviously a buyer’s market.

After a search, my friend found an attractive option, a high-end, dual-inboard, relatively new yet used model, suited for planned outings across one of the Great Lakes. He called and offered what he knew was a ridiculously lowball offer. The salesman responded that he understood why my friend was making such an offer — but he literally couldn’t take it without being fired. My friend said, politely, that was the best offer he would make, and the conversation ended.

48 hours later, the salesman called and asked if the offer was still on the table. My friend got his boat.

About six years later, my wife and I looked for a similar new yet used boat, albeit a far cheaper one for short outings at the far smaller lake next to our home. There were basically none available. Essentially every used boat on the market had been produced no later than 2006; the few people purchasing new boats between that year and 2014 had awfully good reason to do so, and usually little reason to sell quickly.

The point of these stories is that when the boating industry takes a hit, it gets crushed. And the effects linger for years.

We’ve seen this story before. We’re almost certainly going to see it again. And given that the cycle is not the only problem for the space, it seems likely that the decline in boating stocks is closer to the beginning than to the end.

Boating Stocks Sell Off

It’s not a surprise, or a secret, that the boating industry is likely to face challenging times. The six boating stocks publicly traded in the U.S.

But, in context, there’s a pretty strong argument that the pressures facing boating stocks haven’t completely made their way into the market. It’s true that the group is down 38% from the highs; but the entire Russell 2000 has fallen 28% from its own peak. Among stocks with a market cap above $50 million (per a finviz.com screen), the median decline is 32%.

There’s some anchoring bias at play here, certainly, but an investor would expect pretty significant underperformance by boating stocks in a bear market. As we noted in a short overview of the space, that hasn’t really been the case.

Meanwhile, the same broad bearish thesis holds for RV plays as well as boating stocks. Big-ticket purchases are likely to take a hit; inflation is pressuring input costs at precisely the wrong time; the novel coronavirus pandemic pulled forward demand.

Yet those sort-of peers have seen both bigger declines and, at the moment, higher short interest:

Again, there is some anchoring bias at play here, and perhaps RV stocks indeed are better shorts.

But I’d argue the same thesis applies almost equally well to both groups. RV's are a more expensive purchase — but boats aren’t cheap, particularly those sold by the small-cap manufacturers. The steady shift of the U.S. population to warmer Sun Belt areas is a boon for boats — but extends the seasonal usefulness of RVs as well.

Fuel costs are a far bigger problem for RVs; on the Brunswick (BC) Q1 conference call, CEO David Foulkes estimated that higher fuel prices represented a hit of less than $200 for the average boater. But age-related demographics look more positive for RVs; the youngest Baby Boomers (who are about 58) still are aging into the historical sweet spot for that category, but much of that generation is aging out of boating (certainly in terms of high-end/performance markets).

To be sure, boating plays face varying impacts from these trends. But at least on a relative basis, it does seem like investors and short-sellers have focused more on the risks facing the RV space than the boating industry — even though they appear to be largely the same risks.

The First-Time Buyer Problem

Recent and relative performance aside, there’s a strong case that the boating industry is headed for years of pain.

Let’s start with the headline number: annual U.S. powerboat sales. Here’s a chart from 1965 to 2017

In 2018 and 2019, per data from NMMA (National Marine Manufacturers Association), unit sales were modestly above 200,000

The figure then spiked in 2020 and 2021: over 300,000 powerboats sold in each year.

So, for four years (2016-2019), in a pretty solid macro environment, powerboat sales averaged ~200K. In two years in which personal savings soared, travel expenses plunged, the stock market roared, and a pandemic dramatically increased the near-term value of doing anything, the market spiked to 300K-plus.

This quite obviously is an enormous problem. Even disregarding the other risks (macro, fuel, interest rates), it seems like at least a full year’s worth of production was pulled forward into 2020 and 2021. And it does not seem like industry executives expect much different this year. Brunswick, for instance, is guiding for double-digit revenue growth in its boats and engines segments.

The issue for the industry is that cumulative sales are unlikely to change much, if at all. As the chart above shows, new unit sales have been in a multi-decade downtrend. There are no doubt many factors at play: longer useful lives; changing expectations for American men; the changing abilities of those men (notably, far less familiarity with small engines); environmental concerns; the rise of non-motorized competition from kayaks and stand-up paddleboards.

This trend was well known to the industry; in fact, it was generally considered the biggest risk to the industry. As a result, in the middle of the last decade, NMMA itself funded a Discover Boating campaign, and the organization highlighted insights from a late 2016 meeting concerning that program centered on a rather large study from a firm called Info-Link.

Per that study, in a decade, the industry had lost, on a net basis, more than 1 million boaters. And, of particular interest to the space looking to 2023 and beyond, an estimated 54% of first-time buyers in 2005 already had left the activity.

There is zero evidence — zero — that the boating industry somehow fixed its long-running first-time buyer problem.

Pandemic Winners

Instead, the external environment changed dramatically. Indeed, it’s not hard to see similarities between 2005 and 2021. In both years, roaring housing and equity markets left consumers feeling flush. The macro disaster that followed 2005 likely was worse than what we will see in the coming years. But the internal market mechanics that will follow 2021/2022 are going to be absolutely brutal.

The problem is not just that people who bought a boat in 2020 and 2021 won’t be in the market to buy another one in 2023. The problem is that many of those buyers are going to sell those boats in 2023 and 2024. The value of a boat during a pandemic was exponentially higher than it will be at any point, ever again (good Lord willing). The opportunity to use the boat was far greater than normal; the alternatives to its use were far fewer.

It was rational for some buyers to say, “Screw it, we need something to do before we go crazy, let’s just buy a boat and we’ll figure out what to do with it later.” Well, later has arrived.

What we saw in the 2000s was a flood of buyers into the market; and soon after, a flood of relatively new used boats on the market. (Hence, my friend’s enormous negotiating leverage.) The impact of macroeconomic weakness on demand for new boats was amplified by increasing competition in the used market. Again, more than half of 2005 buyers were gone within a decade; it would seem likely that a good chunk of those departures came sooner (amid the financial crisis) rather than later.

There seems little, if any, chance that history is not going to at least rhyme. If anything, there’s more reason for the 2020 and 2021 cohorts to leave relatively quickly, given that many made their decision at least in part due to temporary circumstances. 2005 buyers did the same, and, again, we have no evidence that permanent attitudes toward boat ownership have changed.

So if the industry sold a couple of hundred thousand more units than it might have otherwise, that’s a source of pressure on unit sales going forward. If a chunk of those units head to the used market with less than 100 hours on them, that pressure gets multiplied.

This thesis has echoes in the market: it argues, essentially, that boating companies were pandemic winners. The short thesis for the industry is that the market doesn’t quite appreciate that fact, and particularly the extent to which history suggests new unit sales over time are close to a zero-sum game.

Some 2020 buyers no doubt wouldn’t have been captured otherwise. Many, however, will do what their mid-2000s counterparts did and move on. The happiest days in a boat owner’s life are the day he buys a boat — and the day he sells it.

Pumping The Brakes (Or, More Accurately, Jamming It Into Reverse)

As always, it’s worth considering the contrarian view here. And, to be fair, the industry perhaps does have some things going for it.

One is the fact that unit sales, on their own, do not reflect the industry’s strength since the financial crisis:

source: NMMA via BoatTest.com

Even before the pandemic, pricing had nearly doubled from pre-crisis levels. Boats are better; engines are bigger; features are more useful.

There is a case that the industry can at least manage selling to a relatively stagnant population if it’s offering better products. Brunswick highlights this bull case. Operating margins in the Boat segment in 2019 were above 7%, against a pre-crisis peak just below that figure. In what is now called Propulsion, margins were almost 15% in 2019 and 11% in 2005. (Marine Products (MPX), the other currently public manufacturer that was public before the crisis, sees roughly the same margins, however.)

There are scale benefits as well, given acquisitions across the space. Malibu Boats (MBUU) continues to buy smaller manufacturers including Cobalt and Pursuit; MasterCraft (MCFT) acquired Crest and NauticStar. Brunswick has expanded steadily; dealers MarineMax (HZO) and OneWater Marine (ONEW) too have focused on inorganic growth.

Looking individually at the manufacturers, end markets may also be better than they were in the past (this explains part of the pre-pandemic pricing strength). The performance markets targeted by MBUU and MCFT have outgrown the industry, thanks to the rising popularity of wakeboarding:

source: MasterCraft presentation, June 2019

For those two smaller manufacturers, in particular, the broader concerns created by longer-term industry weakness may not apply quite as heavily. A decent chunk (though not all) of their revenue comes from a category where demand is pretty narrowly focused on specific use cases that can’t be replicated elsewhere.

Brunswick, meanwhile, has continued to build out its parts and accessories (P&A) business, part of an expressed, long-running strategy to mitigate some of the industry’s historic cyclicality. P&A drove 45% of segment-level adjusted operating earnings in 2019, and 36% in 2021 even with pandemic-driven growth in the rest of the business. P&A revenue and profits should, in theory, track to overall boat ownership, not annual sales, perhaps reducing some of the impact of a macro downturn on Brunswick earnings and thus Brunswick stock.

Of course, it’s also possible that current cyclical fears are overblown. Employment remains strong. The housing market doesn’t necessarily have to crash or even weaken all that much. If recession fears prove overblown, there’s potential for a huge snapback rally.

That’s particularly true given the declines since last year’s highs. At this point, valuations suggest the market already is pricing in a cyclical top:

• BC trades at 8.6x 2021 adjusted EPS, and barely 7x the midpoint of 2022 guidance (raised after Q1, by the way).

• After each company reported fiscal Q3 earnings this month, relative to full-year consensus MBUU too trades at 7x earnings, and MCFT 5.3x.

• MPX is at ~12x trailing twelve-month earnings, though without adjustments, and that stock (for reasons that honestly aren’t 100% clear) historically has received a premium to peers.

• The dealer stocks are even crazier. At the midpoint of FY22 guidance (ending September for both companies) ONEW trades at 3.7x earnings. HZO is at 5x, and under 4x excluding net cash. Both companies increased guidance after FQ2.

There’s certainly an argument to be made that the market is well aware of the risks here — and pricing boating stocks accordingly.

The Short Case

Perhaps. But arguing a cyclical business is cheap — or even reasonably priced — based on peak earnings is always a dangerous game. Investors could have made and no doubt did make a similar argument in 2006-2007; boating stocks were crushed:

source: YCharts

Investors can disagree on what, precisely, the industry looks like going forward. But there’s a reasonable path toward a greater than 50% decline in unit sales from current levels. Pre-COVID levels of 200K less pulled-forward demand gets in the range of 150K relatively easily. Macro pressure and financing issues (in terms of both higher interest costs and tighter underwriting standards) suggest the dip could be even greater.

Halve manufacturer earnings and the group is trading at a mid-teens P/E, and in many cases high-teen or 20x-plus P/FCF (capex often exceeds D&A for the sector).

But, of course, in an environment where unit sales are halved, earnings fall even further. Malibu and MasterCraft won’t have huge decremental margins on the way down, as they didn’t have enormous incremental margins on the way up. (The relatively labor-intensive nature of their manufacturing explains why.) Still, there’s some margin erosion from scale, and higher input and labor costs can do the rest. Their higher-priced models (Malibu’s ASP is over $100K; MasterCraft’s ~$75K) might amplify cyclical pressure as well; it remains to be seen just how devoted wakeboarding enthusiasts are when the macro environment deteriorates.

Brunswick has some protection given P&A, but that’s a business that even mid-cycle generally traded at 10-12x earnings. As for the dealers, we’re seeing elsewhere in retail (see Target (TGT)) what operating leverage does when it cuts the wrong way — and what happens when the market starts fearing that deleverage. OneWater’s balance sheet adds another source of concern.

From here, it doesn’t look like even industry pressures themselves truly are priced in. Add in macro risks and cost inflation, and there’s obvious room for downside. There’s a realistic scenario in which unit sales near 100K (they were 130K in 2011), in which case earnings across the sector get crushed. In theory, the market should reprice the stocks accordingly, expanding P/E and P/FCF multiples — but that’s not how it usually plays out. It’s unlikely a nervous market will have that long-term fundamental discipline.

It’s impossible to value boating stocks on pre-COVID results, because a) the companies have brought in a lot of cash and b) acquisitions skew the compares. But going back to the beginning of 2020, the sector still has rallied:

source: YCharts

It’s not at all clear that the stocks should be up at all from trading levels at the beginning of 2020. The forward-looking environment seems far, far worse across the board. The macro picture is worse; costs have spiked; demand has been pulled forward. The equity market, certainly, looks like it will be less forgiving. This absolutely can get worse.

Picking A Target

The thesis behind shorting the sector leads to a question: which stocks, specifically? Each has a case, but beauty is probably in the eye of the beholder. Quickly, and in order, these would be my targets:

1. OneWater. Yes, valuation looks ridiculous at less than 4x EPS. But as the narrative changes (the stock already has been nearly halved), this looks like a classic short. The balance sheet is ~1x net leveraged even excluding floor plan financing. Adjust those earnings for plunging unit sales, higher promotional activity (of which there’s been little of late; no need to discount models that manufacturers can’t produce), and labor/cost inflation and that leverage ratio moves in a hurry.

2. Malibu. It’s a close race between MBUU and MCFT; we’ll go here with the higher valuation. Simple reason for a short: a company selling $100K-plus boats is going to get hammered in a downturn, particularly given other industry pressures.

3. MasterCraft. See above, basically.

4. MarineMax. Better balance sheet than OneWater, but the high short interest is the market telling us something.

5. Marine Products. At varying points last decade, I owned each of the other three manufacturers. I thought MPX was clearly the weakest of the group. That’s probably still the case, but MPX has underperformed and it’s historically held up.

6. Brunswick. P&A helps. Scale matters. Lower ASPs (78% of boats under $50K, per the Q1 call) are a benefit. Brunswick doesn’t escape a downturn, but it’s exceptionally unlikely to be the best short of the group. (To be sure, it’s equally unlikely to be the worst if the thesis is wrong.)

Different investors can pick and choose here. The nature of the portfolio plays a role. But whether shorting or hedging, betting against the space seems attractive. The group might be down 30%-plus already — but there’s certainly room for another 30%-plus to go.

As of this writing, Vince Martin has no positions in any securities mentioned, but may initiate a short position in any of these securities this week.

Tickers mentioned: ONEW 0.00 MBUU 0.00 MCFT 0.00 MPX 0.00 HZO 0.00 BC 0.00

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.