Fox Factory Holding: A Reassessment Given Current Conditions

As an investor, it's important to remain flexible in your thinking. You should never be ashamed to change your stance on an investment prospect if the data calls for it. I used to struggle with this a lot when I first got into the investment industry. But as time progressed, self-reflection became easier. And while I wish I never needed to change my stance, I do so more readily now than ever before. This article is about one such instance. And that involves a business called Fox Factory Holding Corp. (NASDAQ:FOXF). For those who don't know, Fox Factory engages in the production of products and systems that are used in equipment such as bikes, on-road vehicles, trucks, snowmobiles, and more. Recently, financial performance for the company has been a bit mixed, but management remains optimistic about the future. Even so, this, combined with how shares are priced and combined with changing market conditions, has led me to take a more cautious approach to the firm. The end result here has been my decision to downgrade FOXF stock from a ‘buy’ to a ‘hold’ to reflect my view that its return prospects for the foreseeable future should be more or less in line with what the broader market should experience.

Assessing recent weakness

Back in early November of last year, I found myself revisiting Fox Factory to see whether or not it made sense to keep the company rated a ‘hold’. Despite volatility leading up to that point, I felt as though the fundamentals of the company were strong enough to upgrade the company to a ‘buy’. So far, that call has not worked out exactly as I had hoped. While the S&P 500 is up 10.2% since the publication of that article, shares of Fox Factory have seen downside of 0.1%.

This return disparity may seem odd to those who look at just the annual data reported by management. Consider, for instance, the chart above. During 2022, revenue for the company came in at $1.60 billion. That's 23.4% above the nearly $1.30 billion reported one year earlier. Profits during this time increased nicely, popping up from $163.8 million to $205.3 million. And all other profitability metrics followed suit as the chart demonstrates.

But when you start looking at more recent data, the picture is not quite as positive. During the first quarter of 2023, sales came in at $399.9 million. That translated to a sizable increase of 5.8% over the $378 million the company reported one year earlier. Interestingly, this rise in revenue came even as sales associated with the company’s Specialty Sports products plunged 30% from $169.9 million to $118.9 million. That drop, according to management, was driven by a return to seasonality and pre pandemic market conditions. Clearly, during the pandemic, customers invested heavily in these types of offerings. Fortunately, this drop was more than offset by a 35% surge in revenue associated with the company’s Powered Vehicle products. This brought sales up from $208.1 million to $281 million. Even though the company reported a decrease in demand associated with its OEM customers, it experienced strong performance in its upfitting product lines.

The revenue is not exactly the problem though. The bigger issue is the volatility the company experienced on its bottom line. Consider net income. During the first quarter of the year, Fox Factory reported net profits of $41.8 million. This was down from the $48.1 million reported one year earlier. This decline came even as the company's gross profit margin improved from 31.8% to 33.3%. The bigger problem came from increases elsewhere. One of these investors should be completely fine with. And this is research and development. This grew from 3.3% of sales to 3.8%. I rarely have a problem with higher research and development costs since, in theory, it is essentially an investment in the company's future. However, at the same time as this, general and administrative costs expanded from 6.8% of sales to 8.4%. This rise, according to management, was driven by higher employee headcount and benefit related costs, an increase in legal and professional fees, and higher insurance and facilities costs.

Although net profits worsened during this time, overall cash flows for the company were better off. Operating cash flow, for instance, went from negative $143.1 million to negative $66.8 million. If we adjust for changes in working capital, we would see this number improve from $53.3 million to $63.1 million. And finally, EBITDA for the enterprise expanded from $71.8 million to $79.2 million.

Despite the troubles on the bottom line so far, management has high hopes for the future. For 2023 as a whole, revenue is expected to come in at between $1.67 billion and $1.70 billion. Some of this increase over the $1.60 billion reported for 2022 will likely be chalked up to the acquisition of Custom Wheel House that the company announced in February of this year. That enterprise came at a total cost to the company of $131.6 million. That's fairly small, but it should add to the firm's top line. On the bottom line, the expectation is for earnings per share of between $5 and $5.30. At the midpoint, that would translate to net income of $218.9 million. That's a decent increase over the $205.3 million reported for last year. Unfortunately, we don't have any guidance when it comes to other profitability metrics. But if we assume that they will increase at the same rate that net income is forecasted to, we should anticipate adjusted operating cash flow of $267.1 million and EBITDA of $343.1 million.

As you can see in the chart above, I took these estimated figures and priced the company on a forward basis. I also priced the company using data from 2022. As part of my analysis, I also, in the table below, compared the company to five similar firms. On a price to earnings basis, I found that two of the five firms were cheaper than Fox Factory. When it comes to the price to operating cash flow approach, three were cheaper. And when it comes to the EV to EBITDA approach, four ended up being cheaper.

Takeaway

In the grand scheme of things, the picture facing Fox Factory is still fundamentally decent. This year should be better than last year if management is correct. However, in the light of changing market conditions, I am taking a more cautious stance on investments in general. Given how shares are priced, the company is not exactly the cheapest opportunity on the market. This is true on both an absolute basis and relative to similar firms. When you combine that with the bit of pain that the company saw on its bottom line and my overall cautious approach in this market, I believe that a more appropriate rating for the company at this time is a ‘hold’.

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