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Stock Screen: Divergent Returns on Total Capital in the Recreation Industry - June 25, 2012
The Recreation Industry encompasses a broad variety of businesses, from cruise lines to motorcycle outfits to toy makers. One trait that companies in this sector have in common is the discretionary nature of their wares. This makes them highly sensitive to changes in the economic outlook. Indeed, during the last recession, even some of the more defensive names in the sector declined by well over 50%.
Where the industry participants diverge dramatically is in their capital intensity. Certain companies, such as cruise lines and auto racing speedway operators, have heavy capital requirements that often match or surpass earnings, even in the best economic years. The upshot tends to be very high leverage, with many companies having long-term debt in excess of 10 times their 2011 earnings, as well as very burdensome interest payments.
At the other extreme are companies such as toy makers and recreational vehicle manufacturers, where capital spending usually accounts for a mere fraction of earnings. These companies try to avoid large debt loads, and if they can maintain earnings growth without high capital spending, more funds can be allocated directly to shareholders through dividends, share repurchases, and acquisitions.
Since the return on equity equation tends to inflate the returns of companies that are largely debt financed, a better measure for an apples-to-apples comparison of the effectiveness of invested capital is return on total capital, which Value Line calculates by dividing net profits plus half of the current year’s long-term interest due by the sum of shareholder equity and long-term debt. By that measure, it appears that the capital-intensive businesses in the sector tend to get a much lower return on their capital over time. In this screen we highlight four companies, two with relatively low returns on total capital in 2011, and two with higher returns. The complete results of our screen are listed below.
Royal Caribbean Cruises
Royal Caribbean Cruises (RCL) is the world’s second-largest cruise company, with 40 cruise ships in service, and two under construction. The company’s global footprint continues to expand rapidly, with half of its guests expected to be from outside the United States in 2012. In recent quarters, Royal Caribbean has been recovering from the fallout of the sinking of the Costa Concordia, which was owned by its main competitor, Carnival Corp. (CCL). Despite not being directly affected by the accident, the resulting decline in bookings will damage 2012 earnings. However, it is believed to only be a temporary setback, and earnings should recover in 2013.
Historically, the shares have followed the economically sensitive tendencies of the recreation sector as a whole. Similar to the broader market averages, a particularly severe decline occurred during 2008, the height of the Great Recession. The shares were trading near $40 for most of 2007, but bottomed out at $5.40 per share in early 2009. A recovery in the company’s business over the next two years sent the shares soaring to a peak of $50.00 in early 2011.
In terms of long-term fundamentals, Royal Caribbean is the quintessential capital-intensive company. Its capital spending per share has represented a multiple of its earnings per share for most of the last decade. Capital spending there has often exceeded cash flow, leaving no opportunity to pay dividends or make acquisitions. As a result, Royal Caribbean has amassed long-term debt of over $7.8 billion, and a working capital deficit of over $1.9 billion. Much of the capital spending of the last 10 years was directed toward a global expansion initiative between 2008 and 2010. Since then, capital spending has stabilized at a lower level. This may afford the company an opportunity to reduce its debt or raise dividends in the coming years. Further, the company pays virtually no tax due to a loophole that allows shipping companies to incorporate overseas, so their overall tax and interest expenses are manageable, even with high leverage.
Despite so much capital spending, the company’s earnings growth has been inconsistent and highly cyclical, with overall unimpressive results. Its high capital needs and lackluster earnings history have led to an exceptionally low return on total capital, totaling just 4.8% in 2011 despite it being a strong earnings year for the company.
Another capital-intensive company in the recreation sector is Speedway Motorsports (TRK), which owns and operates speedways in Georgia, Tennessee, Texas, Nevada, and California. It sponsors racing events sanctioned by NASCAR, including 13 Sprint Cup races, and several associated with the Busch Grand National circuit. Its 2011 revenue sources were NASCAR broadcasting (37%), admissions (26%), other event related revenue (17%), sponsorships (12%), and event related merchandise (8%).
In the late 90’s, the company’s capital spending often exceeded cash flows by a wide margin. However, this spending has slowed in recent years as the businesses mature. This has allowed it to start paying down its long-term debt, although the tally still stands at more than 10 times the company’s 2011 earnings. Further, Speedway recently raised its dividend by 50%, providing investors with a well above-average dividend yield at the current share price.
The company experienced relatively stable earnings growth from 2000 to 2006, after which earnings plateaued until 2009, when they took a precipitous decline. The company’s earnings have shown little sign of recovering despite a slowly improving economy. This combination of high capital spending and disappointing earnings has led to Speedway Motorsports’ unimpressive 4.9% return on total capital for 2011.
Mattel, Inc. (MAT), the largest U.S. toy maker, is a good example of a recreation sector company with very different business economics. It produces well-known toy lines such as Barbie, Hot Wheels, Tyco, and Matchbox, while also boasting the popular Fisher-Price and American Girl franchises. In recent years, the company has made great strides in developing markets, with Brazil now being its second-largest sales region.
With its relatively simple business model that relies on strong consumer brand names, capital spending has been a modest fraction of earnings and cash flows for the past 10 years, leaving MAT with plenty of free cash flow to go around. The company's debt burden is significantly below working capital, and should easily be covered by earnings over the long term. Its financial strength has allowed it to raise its dividend generously this year, offering a rewarding and well above average yield for shareholders.
Meanwhile, earnings have grown steadily over time. Like most companies in its sector, Mattel’s earnings took a hit during the most recent recession. However, they have recovered strongly in the years since, and the stock price is now more than triple its 2009 low. These factors gave Mattel an impressive return on total capital of 19.6% in 2011, making it an efficient user of capital by most standards.
Polaris Industries (PII), maker of all-terrain vehicles (ATVs), snowmobiles, personal watercraft (PWC), and motorcycles, boasts the recreation industry’s highest return on total capital. Last year’s sales consisted mostly of off-road vehicles (69%), with significant revenues from snowmobiles (11%), on-road vehicles (5%), and Parts, Garments, and Accessories (15%) as well.
As an industry leader in its niche markets, Polaris has been able to grow its earnings strongly over the past few years, and its stock price has skyrocketed since its 2009 low. This year, the dividend payout took a big jump, and with a $285 million cash hoard —which exceeds long-term debt by a large margin— the company can easily afford it. Capital spending accounts for a small fraction of cash flows, and free cash flow looks set to get even stronger in coming years.
These factors have given Polaris a recreation industry-leading return on total capital of 38% for 2011, which also places it on Value Line’s list for Highest Returns Earned on Total Capital. Our main note of caution for investors is to beware of an excessive share price. Although PII shares have declined significantly since our last report, their 3- to 5-year annual total return projections remain below average so we recommend that investors wait for a better entry point.
|Company||Ticker||Return on Total Capital|
|Sturm, Ruger & Co.||RGR||29.13|
|Cedar Fair L.P.||FUN||8.82|
|LeapFrog Enterpr. 'A'||LF||8.55|
|Int'l Speedway 'A'||ISCA||5.5|
|Royal Caribbean Cruises||RCL||4.84|
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.