Balancing Out YETI's Challenges and Opportunities

Just a few weeks removed from its IPO, YETI Holdings (YETI -2.71%) is hoping to attract a following on Wall Street equal to its Instagram following. In this segment from Industry Focus: Consumer Goods, host Vincent Shen and Fool.com contributor Asit Sharma break down its headwinds -- for example, its moderate debt with high associated interest expense -- and opportunities, including westward and international expansion. Tune in for critical context on this rapidly growing lifestyle company.

A full transcript follows the video.

This video was recorded on Nov. 27, 2018.

Vincent Shen: Going back to the use of proceeds that are going to Yeti, the company said they would be using them to pay down debt. Asit, we've talked a little bit about revenue. We've talked about profitability. How about the balance sheet? I know there was something that raised both of our eyebrows and came up as a red flag. Could you go into that?

Asit Sharma: Sure. One of the things that's really important to do, investors, if you're looking at an initial public offering, this is a pro tip -- not that I claim to be a pro -- is to go straight to that use of proceeds section and see why a company is coming to market. Most of the time, the reasons will be obvious if you know even a little bit about the company. It needs capital to grow, it's going to invest in research and development, etc. The total $37 million of net proceeds that was raised, as Vince mentioned, has gone to debt service.

If we look at the balance sheet, Yeti has long-term debt of about $428 million on its books. That's divided between two term loans. They call it term loan A, which is $356 million outstanding, and term loan B, which is about $78 million outstanding. The first loan that I mentioned has an interest rate of 7.6%. The second loan that I mentioned has an interest rate of 6%. Yeti obviously wants to pay down some of this debt. It also has access to $100 million more in terms of a revolving credit facility that's currently untapped.

I crunched some numbers. The debt load is moderate. It's not terribly excessive. I got roughly 3.5X annual EBITDA -- earnings before income, taxes, depreciation and amortization -- which is a middle-of-the-road, creeping up toward higher leverage. But what concerned me -- I think I had dyslexia earlier. That interest expense wasn't $19.6 million. It was closer to $16.7 million. Still, to my point, that's more than net income that was generated in the first reporting period.

With this kind of debt load, slim margins, high interest expense, if some of this revenue generation and revenue acceleration is due to a fad that's going to wane, as Vince has posited -- let's talk about that for a second. One of the things that a company like this may run into is a cash crunch down the road. Adjusted EBITDA numbers are higher. You do want to look at that. But I like to look at the full GAAP numbers -- generally accepted accounting principles. I think those numbers really tell you, over the long-term, what a company needs to generate to stay profitable, have strong cash flow.

Just curious, Vince. To me, this a little bit of a yellow flag, not necessarily a red flag. What are your thoughts?

Shen: Maybe a lowercase, small r, red flag. Looking at that debt load, for a company that's looking to invest and grow, based on what they described as their long-term growth opportunities, $350 million net debt. And I got the same number, about 3.5X debt to adjusted EBITDA. Not outlandish for a company at this stage of its life. At least that debt balance is down from its peak in 2016, when it was over $500 million.

Next up, we're going to look more into the breakdown of this business, particularly with its expansion and some of the other risks that we see with the business.

We've covered the big picture for this company, what they're selling, who they're selling to, some of the things that jumped out to us in the financial statements. Let's turn our attention to what lies ahead for the company. For example, part of that direct-to-consumer distribution, Yeti has that single flagship store that I mentioned in Austin. Management indicates that they plan to gradually open more brick and mortar locations over time. Even though Yeti's popularity has really jumped recently, management paints a picture where the brand is still most prevalent in the United States, and within the U.S., only the South and Southeast regions, what it calls its heritage markets. That presents a runway for growth, with the big outdoor recreational markets that remain in the West Coast, the North, the Northeast. What do you think, Asit? My concern for any company like this always revolves around the idea of how big you can ultimately become. Yeti is selling $700-800 million of coolers and tumblers and water bottles right now. How much bigger kind of business like this realistically get? What do you think?

Sharma: I think it has a chance to keep growing at a good clip. Some of the markets that are open to it -- say, the Northeast -- aren't quite as conducive to the hunting and fishing ethos which fueled its first line of growth. But as you pointed out, more sales to women, more non-traditional customers are buying the products. If you look at this map of the Southeast and picture all the blank space that exists in the Midwest, the West Coast, there is a large westward and northward expansion that the company has available to it.

One of the strategies that it's trying to use is to expand drinkware sales. As I mentioned before, drinkware sales increased by $58 million, or about 49%, to $177 million in the first six months of this year compared to the prior year. But the flip side of that is, those are presumably much lower-margin sales than those $1,300 coolers. It's also trying to increase corporate branded sales in this direct channel. And, also, international markets. This is something that most investors wouldn't natively think, myself included, about Yeti, but it's already established markets in Australia and Canada in 2017. It entered Japan in 2018. Listeners, I mentioned a few times on different shows that unique culture in Japan of liking nice things and acquiring great products. We talked about this in relation to Sonos when it had its IPO. I think that's a smart market. It's looking at Europe. It's also looking at Asia, particularly China, outside of Japan. If we consider all that together, I think there is a pretty good market for this company to expand. I do like the strategies that it's putting forward.

However, I'm concerned, Vince, with what you mentioned. So much of this has been fueled by the desirability of the Yeti brand. We were chatting with our producer Austin before the show, and he was telling us how popular it was on Instagram last year. How sustainable is that advantage? Will other competitors come, especially in this drinkware portion where it wants to expand, and take some market share? What do you think?

Shen: I'll just say, with the international expansion, which I thought was really interesting, going to Canada and Australia last year, then going to Japan. Something I will play a little bit of devil's advocate with is that these are still very early efforts. Yeti themselves say they're just trying to get their name out there, build up brand awareness. It's likely to take at least a few more years before the company sees any kind of material contribution from that international segment.

On the flip side, in terms of being more of a supporter of this possibility, I'm usually pretty skeptical of international expansion as a source of significant long-term growth for a company that doesn't have any kind of proven track record yet outside of its home market. But I also think that Yeti is a company that has proven itself very savvy with marketing, with establishing what they've described as an aspirational nature of their brand. They have these Yeti ambassadors, famous hunters and fishermen, even surfers and barbecue pit masters. I thought that was really cool. They have a really big social media following, which you mentioned.