IB Equity Research

September 19, 2013

WEST MARINE, INC. Thesis Overview

West Marine is an undervalued retailer. The company is going through a change in focus from a bricks and mortar boat product retailer to a fully integrated retail and wholesale business through bricks and clicks, targeting the boating and water enthusiast customer. Recent results have been affected by a severe rainy and cool spring which hurt boat usage and delayed the start of the season. The company has accelerated cash investments to build larger more productive stores and expand its ecommerce abilities, consequently affecting free cash flow short term. The stock lacks sponsorship as there is only one research report written on the company by a small boutique firm. The stock trades at only book value despite the company being the leading industry player with a solid balance sheet and significant net cash position.

Stock Rating Catalyst Category Price Target Price (9/19/13): $11.88 Upside/(Downside): 43% Ticker: WMAR Exchange: NASDAQ Industry: Boating / Specialty Retail Trading Stats ($USD millions) Market Cap: $290 Enterprise Value: $245 Price / Book: 0.96x PEG Ratio: 1.15x Dividend Yield: 0% Price / 2013E EPS: 28x Price / 2014E EPS: 15x EV / 2013E EBITDA: 7.4x EV / 2014E EBITDA: 5.6x
Source: Company filings, Wall Street Consensus

BUY Value $17.00

Price Performance 52 Week range: $9.30 - $13.20 Analyst Details IB Username: JudyR2K Employer: Juniper Investment Co Job Title: Portfolio Manager Analyst Disclosure WMAR Position Held: Yes

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September 19, 2013

Company Overview
West Marine (WM, ticker WMAR) is the largest specialty retailer of boating supplies and accessories. There are approximately 12MM registered boats in the US and over 22MM total. US boaters spend 3 billion hours annually on the water. The boating supplies business is roughly a $5B worldwide market and WM has about a 13% share today. The company began as West Coast Ropes in the founders garage. He still owns 30% of the company today. WM has almost 300 stores in 38 states, Puerto Rico and Canada (10), and 5 franchised stores in Turkey. International sales are less than 5% of the total. The stores are located primarily on the coasts near the boaters. The company has tried inland strategies in the past that were mostly unsuccessful. Below is a map of store locations:

The company also runs a wholesale distribution business called Port Supply, which sells boating products to commercial customers. Given its scale, WM has the most buying power and best supply chain in its industry. The company historically reported 3 segments: Stores, Port Supply and Direct-to-Consumer (i.e., catalog, internet and call center transactions). Segment details as follows:

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September 19, 2013

2012 Revenue Breakdown

Direct-toConsumer 6% Port Supply 4%

2012 Contribution Breakdown

Direct-toConsumer 8%

Stores 90%

Stores 92%

Note: Port Supply excluded from Contribution Breakdown as it contributed -$3,8 million in 2012

WM has now integrated all systems into one reportable segment and looks at its business as one omni-channel retailing.

Management History and Strategy

WM brought in Matt Hyde, 50, as president and CEO in May 2012. The company needed direction in the new integrated world of offline and internet retailing with heightened online competition. Matt had been an EVP for REI, a national retailer of outdoor gear and clothing. He was responsible for REIs stores, direct-to-consumer/ecommerce marketing and real estate. In an earlier position, he repositioned and successfully grew the companys private label brand. He also sits on the board of Zumiez (a specialty retailer of action sports related apparel), and the YMCA. Tom Moran, 52, is the CFO. He joined the company 7 years ago and has a strong consumer background with Carmax and Limited Brands. Matt Hyde and the management team have introduced 3 key strategies to grow the business: ecommerce, merchandise expansion and store optimization.

Ecommerce
Matt successfully led REIs ecommerce business from 0 to $100MM. At WM, he initiated a major investment program in 2013 to support information technology investments for network and website improvements, and to replace aging software and hardware. Sales through the direct channel increased 13% in 2013. The companys ecommerce website offers customers 75,000 products (compared to 8,000 18,000 SKUs in the stores), unique advisor tips and technical information, and over 12,000 product videos and customer reviews. The company runs a virtual call center to assist sales generated through its website, catalogs and stores. Fulfillment of direct orders is completed through its distribution centers. The company changed its promotional strategies (i.e., reduced hurdle for free shipping) and improved the buy-on-line-ship-to-store offering.

Merchandise Expansion
WMs merchandise expansion strategy aims to attract a broader base of customers who enjoy recreational water sports and lifestyle. The company wants to be knows as a lifestyle retailer and not just a parts retailer. The company expanded its selection of footwear, apparel, clothing accessories, fishing products and paddle sports equipment. These products are available in the larger stores and online. The merchandise expansion categories comprise over 15% of total revenues and have comped significantly higher than the core products. For the first half of 2013, core categories declined 3.5% whereas the merchandise expansion categories comped positive 4.3%. Private label runs about 22% of total sales.

Store Optimization
WMs real estate optimization strategy focuses on increasing ROIs on store assets. The company is evolving to have fewer, larger and more dominant stores in their major markets. These stores allow for an improved shopping experience with greatly

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September 19, 2013

expanded assortments in better locations. Store associates also have more specialized product knowledge. Net square footage for the company is staying constant as larger stores replace multiple smaller stores, but sales per square foot in optimized markets is growing. Almost all new stores are meeting or exceeding the 15% incremental ROI hurdle and the 4-wall contribution is accretive in the first year. During the first half of 2013, sales in stores in optimized markets increased 20%. WM operates large format stores (13 19,000 sq. ft.), standard-sized stores (6 12,000 sq. ft.), and express stores (2,500 3,000 sq. ft.). Flagship stores can range from 20,000 50,000 sq. ft. depending on the market size. The overall company average is currently 9,000 square feet. The company is over 50% completed on its real estate optimization process. Today it runs 47 optimized markets spearheaded by 13 flagships and 34 large format stores. To put this in some perspective, in 2007, WM had 372 stores and today it has 295. Square footage is relatively unchanged throughout. The remaining markets will be completed over time depending on lease expirations, cash flow availability to fund capital expenditures, and real estate opportunities. There are still a few major markets left to do (Miami, San Francisco). Below is a history of store count:

Selling Sq Ft (MM)

2.8

2.7

2.7

2.7

2.7

2.7

~2.8

Wholesale
WM also has a thriving wholesale business called Port Supply. The company offers same day delivery to domestic and international wholesale customers out of 21 large stores which serve as hubs. It offers 3 pricing tiers (gold, silver and bronze) depending on volume of business. Gold is the most competitive price on annual sales for volumes over $25,000 a year. Bronze is only slightly better than retail. The largest wholesale customer represents less than 1% of total Port Supply revenues. Customers include businesses involved in boat sales, boat building and repair, yacht chartering and marina operations. Port Supply also sells to some government and industrial customers. The wholesale business helps leverage the companys purchasing and distribution operations. The bulk of WMs customers are members of its West Advantage Loyalty program. C ustomers fall into 2 levels. Gold membership costs $19 per year and gives a customer a free membership in Boat U.S., a towing service. Customers receive

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September 19, 2013

promotions through email and earn loyalty points based on their spending levels. Silver membership is free and customers also receive loyalty points, albeit at a slower rate.

Competition
In retail, the company competes with many brick and mortar retailers as well as online merchants. Its biggest competition from retail stores is from Bass Pro Shops and Wal-Mart (NYSE: WMT). On a lesser degree, it competes with Cabelas and Gander Mountain. Online they face Amazon (NASDAQ: AMZN) and Google (NASDAQ: GOOG) shopping as well as some small regional players like Defender.com. Price competition is fierce bu t they do maintain price integrity by matching others offers. Its wholesale business competes with Brunswick (Land and Sea), Donovans and Fisheries among others. As the company grows its merchandise breadth, it competes more with sporting goods stores and apparel retailers.

Acquisition History
WM is not looking to grow through acquisition. The company had acquired other chains in the past and found the deals unsuccessful. It acquired 63 Boat U.S. stores in 2003 which initially increased its sales by 25%. WM ended up closing most of those stores over time. In 2009, one of their largest competitors, Boaters World, liquidated 125 stores through bankruptcy. Through all this, WM continued to generate cash and maintain its industry leading position.

Recent Financial Performance

Recent results have been disappointing. The company has had to lower guidance significantly the past two quarters. This past spring was incredibly rainy and the boating season got off to a very late start. Although one hates to blame weather, this certainly is a legitimate gripe this year. Additionally, the NJ region was affected by hurricane Sandy, and many boats did not make it into the water this season. Industry data available in the regions of the US impacted by weather showed ramp fees, marina gas sales, and boat slip usage down 15 30%. Conversely, in CA, where the weather was more typical, WM realized an increase in sales in the 2nd quarter of almost 4%. Weather aside, the boating industry news has been quite positive. Boat sales have increased nicely this year based on results from Brunswick (BC), Marine Products (MPX), and Marinemax (HZO). New boat sales are a leading indicator for boat accessories. Although usage was down significantly this season, there are more boats out there to serve next season assuming the sun comes out again. Gross margins declined 30 basis points year over year due to a shift in mix to more wholesale sales relative to retail. The retail business is more impacted by shorter term issues like weather, and wholesale sales run lower margins due to purchase volume discounts. The company has managed inventory quite carefully given the replenishment nature of the business and cash flow has stayed strong. In fact, WM is sitting on $45MM in cash and no debt. Cash should finish this fiscal year about where it started despite almost $30MM in capital expenditures to support the new large stores and technology investments. Cap ex is about $10MM greater than the prior year due to these additional investments. I would expect the cap ex budget to be down next year and, over time, drop significantly once the store optimization program is completed.

Valuation
WM has a book value of almost $12.00 per share. The stock is trading below that due to current disappointing results. That being said, the stock has stayed relatively range bound between $11 and $12 despite the dramatic cut in guidance. With the rock solid balance sheet and asset support, its hard to see this stock going too much lower. I believe the best public comps ar e Destination XL (DXLG) and Destination Maternity (DEST). Each of these is a category killer specialty retailer in its respective niche (large size men and pregnant women). There is very little top line square footage growth in either case given how mature

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September 19, 2013

their concepts are. They are each running their own store/real estate optimization programs replacing many smaller stores with fewer larger stores. Each is also focused on growing their ecommerce revenues.
2013 EV/Sales EV/EBITDA 0.85x 20.4x 0.70x 7.0x 0.78x 0.34x 13.7x 7.4x 2014 EV/Sales EV/EBITDA 0.75x 11.6x 0.69x 6.5x 0.72x 0.32x 9.1x 5.6x

Company Destination XL Destination Maternity Average West Marine

Ticker DXLG DEST

Price / Book 3.30x 3.40x 3.35x

WMAR

0.96x

One can also look at the valuations of the 3 public boat manufacturers/retailers. Brunswick is in other businesses aside from boats, but boating is a big part of its business.
2013 EV/Sales EV/EBITDA 0.85x 20.4x 0.68x 27.4x 1.76x 30.0x 1.10x 0.34x 25.9x 7.4x 2014 EV/Sales EV/EBITDA 0.75x 11.6x 0.61x 13.9x 1.65x 25.0x 1.00x 0.32x 16.8x 5.6x

Company Ticker Brunswick Corp BC Marinemax HZO Marine Products Corp MPX Average West Marine WMAR

Price / Book 3.30x 1.30x 4.00x 2.87x 0.96x

DXLG and DEST saw nice moves in their stocks over the past year as their strategy started to prove out and the comps turned nicely positive (also helped out by the economic pickup). BC, HZO, and MPX also had nice stock appreciation as orders and sales grew with the economic pickup. WM is not too far behind. The company is now set up for very easy sales comparisons next season due to the difficult year it is experiencing this year as well as benefit from the infrastructure investments it is making.

Risks
The obvious risk to this story is another economic slowdown hurting the consumer. A bigger risk in my opinion is continued increased online competition. Amazon and others are a threat there is no denying that. But many category killers have survived nicely right alongside Amazon. WM offers a loyalty program, ease of shipping and returning, competitive pricing, and knowledgeable boating salespeople.

Expectations & Target Price

The company has increased capital spending significantly this year to build an enhanced ecommerce platform and open some new large format stores. These will all benefit WM next year, along with the easy sales comparisons. The company also has a great opportunity to expand its customer base through its merchandise expansion program and Port Supply business. Next year should also see a nice growth in the cash balance due to a combination of reduced capital spending and dramatically improved results. At some point, if cash continues to grow and the stock price stays stagnant (trading below book value), this business will start to show up on private equity screens if it hasnt already. IN 2006, WM had $63MM of net debt. Today they have a net cash position of $45MM which could double over the next 3 years. If you put a similar multiple on WM that any of the public comps receive, this stock could easily trade between $14 - $22 over time.

IB Equity Research
September 19, 2013

Financial Overview
($ in millio ns, except per share data)

FY end Dec 31: 2010 Sum m ary Incom e Statem ent Total Revenue $ 622 % Growth COGS % of Sales Gross Profit Gross Margin % Operating Income % of Sales EPS EPS Growth % $ 447 71.9% 175 28.1% 15 2.4% 0.58

2011 $ 643 3.4% 458 71.2% 185 28.8% 22 3.4% $

2012 675 5.0% 477 70.7% 198 29.3% 25 3.7% $

LTM 661

470 71.1% 191 28.9% 21 3.2% 0.49

$ 1.27 119.0%

$ 0.67 (47.2%)

Sum m ary Cash Flow EBITDA EBITDA Margin Cash Interest Cash Taxes Capital Expenditures Free Cash Flow as % Sales

15 $ 36 $ 41 $ 37 2.4% 5.6% 6.0% 5.6% 2 (4) (7) (7) (14) (18) (18) (25) 3 0.5% $ 14 2.2% $ 16 2.3% $ 5 0.8%

Sum m ary Balance Sheet Cash & Equivalents $ Total Debt $ Net Debt / EBITDA

22 -1.5x

$ $

44 -1.2x

$ $

56 -1.4x

$ $

58 -1.6x