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Smith & Wesson (SWHC) Took a Bullet but is Ready for Growth

October 01, 2010 | About:
About the Company

Smith and Wesson is one of the most well respected brands in the firearm industry worldwide. Its history dates back over 150 years. It is most known for its revolvers, which were used even during the Civil War. Today, the company is more than just a manufacturer of revolvers. It produces other firearms such as pistols, tactical rifles, hunting rifles, shotguns, and black powder firearms, as well as related accessories such as handcuffs. Also, recently, the company entered the perimeter security business through its acquisition of Universal Safety Response, which provides various security barrier products for pedestrian, traffic and access control, as well as detection systems for restrictions on vehicle height, wrong way or reverse entry, and speed.trans.gif

Firearm customers include gun enthusiasts, collectors, hunters, competitive shooters, law enforcement and security agencies and officers, military agencies, and individuals who seek personal protection. Perimeter security customers include corporations, military bases, federal and state officers, airports, and other governmental organizations.

You might think that a company with such a great brand name would possess a moat that would allow it to keep its competitors at bay and generate handsome returns for its shareholders. The brand definitely has a lot of potential, but unfortunately, the company was mismanaged until December 2004 when a new CEO was hired to turn it around.

History

The company was founded in 1852 by Horace Smith and Daniel Wesson as a partnership under the name Smith & Wesson Arms Company. Because of financial problems, they brought in an outside investor, Oliver Winchester, and changed the name of the company to Volcanic Arms Company. In 1855, Smith decided to leave and Wesson soon followed. In 1857, Smith and Wesson started a new partnership and produced their first revolver.

In 1873, Daniel Wesson purchased Horace Smith’s interest in the company. It stayed in the hands of the Wesson family until 1964. Since then, the company has changed hands many times.

Problems

Even though the company possessed one of the best brands in the world, this alone did not ensure prosperity. Problems started in the 1980s when foreign gun makers aggressively entered the U.S. market, targeting the law enforcement market, which at the time belonged almost exclusively to Smith and Wesson. The company completely ignored the threat from foreign competitors. For example, when Glock, an Austrian gun manufacturer, introduced a polymer pistol, Smith and Wesson did not think much of it because the management thought that police officers would not carry plastic guns. They failed to put themselves in the shoes of these officers who were not of the same opinion because they were the ones that had to carry metal guns, which were much heavier than the newly designed Glock pistols. Also, the new pistols held more bullets and had more firepower than Smith and Wesson’s revolvers. Because the company did not offer a competing product, it slowly lost market share to its foreign competitor.

Besides losing battles with foreign competitors, the company faced another problem in late 1999 when the Clinton administration threatened to bring a national lawsuit against firearm manufacturers on behalf of the country’s public-housing authorities. Consequently, Smith and Wesson decided to work with the administration and adopted some “gun-safety” measures such as requiring background checks for buyers. This infuriated customers and dealers who then boycotted the company. They believed that they had a Constitutional right to carry guns and felt betrayed when Smith and Wesson cooperated with the administration. This obviously was detrimental as many customers and dealers suddenly stopped conducting business with Smith and Wesson. During this time, the company was owned by a British conglomerate, Tomkins PLC, which, out of distress, chose to sell the company at a fire sale price.

During the next two years, the new management worked on restoring confidence and putting the company back on its feet. Unfortunately, they hit another roadblock because the Securities and Exchange Commission started an investigation of the company’s accounting practices because of the questionable way in which it recorded one of its acquisitions. Finally, in 2004, the board of directors decided to seek help.

In November 2004, the board of directors hired Michael F. Golden to be Smith and Wesson’s CEO. When Golden first received a call from a headhunter inquiring about his interest in the position, he recognized the name of the company, but was not sure if he was the right person for the job because his specialty was marketing and he knew nothing about firearms.

However, after learning about the company’s problems, he knew that he could turn it around because his previous employers, Black and Decker, and Kohler Company, had faced very similar problems. Smith and Wesson lacked leadership as there was no one at the top to set the company’s direction. Employees were producing parts that were not needed. Sales representatives did not have any measurable goals of how much they need to sell. Entire markets were being ignored. Despite these problems, he felt confident because the company had one major strength – a fabulous brand name. In his book, Lessons of a Brand Manager, Golden said about Smith and Wesson, “I knew how powerful a well-managed brand could be, especially in the hands of a skilled management team.”

Turnaround

Before executing a turnaround strategy, Golden had lots to learn because, as I mentioned before, he was completely clueless about the firearm industry. He chose to accomplish this by talking with employees and asking them many questions. He first talked to employees in the corporate office and then proceeded to the factory floor. He thought that the listening campaign was extremely important because of two reasons that he mentioned in his other book, No Company Runs Itself, “First, you can never really know what’s going on in a plant or an office unless you go there yourself and talk to people one on one. Second, all of us like to feel that we can make a contribution and that our ideas are worth listening to.”

Soon after his crash course on the firearm industry, he was ready to make some changes. To help him execute the turnaround strategy, he needed a strong management team. To supplement the current management team, he brought in several executives from the outside who possessed excellent branding experience. He then required all the senior managers to meet daily so that everyone would finally be on the same page as far as the company’s direction and progress towards it.

In the middle of 2005, the new management team reorganized Smith and Wesson’s sales force. In the past, the company had been using many independent sales representatives, but a study showed that internal sales representatives were much more productive, so the management decided to convert many of the independents into Smith and Wesson’s employees.

In the past, the company mainly focused on the retail revolver market where it commanded 38 percent of market share and on the retail semiautomatic pistol market where it commanded 10 percent of market share. While Golden believed that there was more room to grow within this core market, he thought there was even more growth potential in other markets.

To gauge the Smith and Wesson brand, the brand research team conducted a survey that asked 4,000 people to rate the company in specific categories of firearms. It was no surprise that Smith and Wesson ranked first in the revolver and pistol categories but what amazed the management was that the company was rated third or fourth in shotguns, bolt-action hunting rifles, ammunition, and alarm systems for homes. The reason why this was such a surprise was because Smith and Wesson was not involved in any of these markets at all.

After a survey like this, it was pretty clear that the company needed to enter different markets. However, it first focused on strengthening its handgun business which sold to four channels: retail customers, state and municipal police departments, the U.S. Military, and international sales. In the past, Smith and Wesson concentrated mainly on the retail sector and almost completely ignored the other three channels. With the newly reorganized sales force, the company was ready to make some progress with the other three channels. With the Smith and Wesson brand name, sales representatives were able to get appointments with decision makers.

To market to state and municipal police departments, the company hired Bryan K. James and Douglas Grier III, who were both former Glock sales leaders. James became Director of Law Enforcement Sales, and Grier became Regional Sales Manager for Law Enforcement in the mid-Atlantic region. On the product side, the company introduced the M&P 40 (military and police) handgun which turned out to be a success.

To generate business from the military, Golden, himself, spent a significant amount of time in Washington rubbing elbows with the appropriate decision makers. Because Smith and Wesson was an American company with such a recognizable brand name, people were willing to talk with him and some even wondered where Smith and Wesson had been for so many years. Then, the company hired Ernest Langdon to fill the position of Director of Federal Law Enforcement and Military Sales. Langdon was the perfect candidate for this position because he was a former provider of custom pistol parts and services, tactical training, and consulting services to law enforcement and military agencies. Because he operated from Washington D.C., he was close to the proper decision makers.

Outside of the handgun market, Smith and Wesson entered the long-gun market for rifles and shotguns, which was 60 percent larger than the market for handguns. Because the previously conducted survey showed that people were willing to buy these products from the company even though it did not produce them, the management felt confident that this would be a profitable route to take.

Because Smith and Wesson was a publicly traded company, Golden knew that it was important to clearly communicate the company’s strategies and results to buy and sell side analysts and current and future investors. To accomplish this, he hired Elizabeth A. Sharp to fill the newly created position of Vice President of Investor Relations. She had 20 years of experience in corporate communications and investor relations.

Turnaround Results

Did all the efforts pay off? They most certainly did because net product and services sales increased from $118 million in 2004 to $406 million in 2010. Net income increased from less than $1 million in 2004 to $33 million in 2010. The company was showing progress in its pursuit to diversify away from revolvers which constituted 41 percent of net product and services sales in 2006. By 2010, this number was at 19 percent.

When Golden was hired on November 11, 2004, Smith and Wesson stock closed at $1.45 per share. Three years later, on October 29, 2007, the stock closed at $20.09 per share. This represents a 1,286 percent return. What a fabulous run! Up until that point, everything was going well. Police departments all over the country were switching to Smith and Wesson’s products. The company was winning new military contracts. The stock started trading on the NASDAQ and soon became included in the Russell 2000 and 3000 Indexes. The company was recording record sales and profits, and was raising money through the private placement of common stock with institutional investors. It even acquired Thompson/Center Arms, Inc., a 40-year old manufacturer and marketer of premium hunting firearms, with a superior brand name.

The Long-Lasting Pain

On October 29, 2007, the party came to an end after Smith and Wesson reported the preliminary second quarter financial results which caused the stock price to go from $20.09 that day to $12.12 the following day, which is nearly a 40 percent decline in a single day. Then exactly, one year later on October 28, 2008, the stock closed at $1.58 per share. Ouch! Today, it is trading at around the $3.60 per share range.

When the company reported the preliminary second quarter financial results on October 29, 2007, Golden said that even though the sales growth was strong, the results were impacted by several factors such as softness in the hunting rifles and shotguns markets, weaker consumer demand, build up of retail inventories, and warmer than expected weather, which caused retail traffic to fall.

From there, retail sales continued to decline and the management kept lowering its guidance and on January 22, 2008, it finally suspended providing financial guidance. Golden explained it by saying, “We, like many other companies doing business today, find ourselves now in an uncertain business environment.”

While the management looked brilliant when it acquired Thompson/Center Arms, Inc. for $102 million in January 2007, it now looked foolish because the newly acquired company became a drag on cash flow. Thompson/Center Arms manufactures hunting rifles, which are discretionary purchases and as the economy deteriorated so did these sales. To deal with the decline in sales, Smith and Wesson had no choice but to cut costs and lay off 86, 80, and 66 workers in March 2008, September 2008, and January 2009, respectively. These cuts represented almost 50 percent of the original workforce upon acquisition.

Because Smith and Wesson acquired Thompson/Center Arms for its brand name and technological expertise, the majority of the sales price was allocated to goodwill and intangible assets. Consequently, on December 15, 2008, it announced a huge, $76.5 million, non-cash impairment of goodwill and intangible assets associated with the acquisition. In other words, the management acknowledged that it wasted $76.5 million of shareholders’ money by overpaying for the Thompson/Center Arms acquisition. To make matters even worse, the company borrowed money to finance part of this acquisition. Part of this debt is still on the company’s balance sheet.

Analysis

While the company overpaid for the Thompson/Center Arms acquisition and parts of its business slowed down during the recession, these factors don’t disqualify it as a possible investment. I agree that the acquisition turned out poorly, but it is hard to blame the management for not being able to predict the worst recession since the Great Depression. Ever since Golden took over, he has completely transformed the company. Even though the average retail customer spent less on firearms during the past few years, other sales channels followed a different trend. For example, over this time, the company kept winning contracts with various law enforcement departments throughout the country. Also, on July 21, 2009, Smith and Wesson completed the acquisition of Universal Safety Response, Inc., which allowed it to enter the rapidly growing perimeter security market. This will further diversify the company away from retail firearm sales.

In order to determine whether investing in Smith and Wesson makes sense, it is better to examine exactly where the company is today and where it is likely to be in the future instead of focusing on the past.

Based on the information that the company provided, I reconstructed the following income statement:

MarketMarket ShareRevenues
Revolvers$244,000,00032.00%$78,080,000
Pistols$1,020,000,00012.00%$122,400,000
Hunting Rifles$630,000,0004.00%$25,200,000
Tactical Rifles$420,000,00015.00%$63,000,000
Black Powder Rifles$50,000,00038.00%$19,000,000
Total Firearms$307,680,000
Non-Firearms$20,000,000
Perimeter Security Division$75,000,000
Total Revenues$402,680,000
Net Profit Margin6.00%
Net Income$24,160,800
Today, total revenues are slightly over $400 million. Sales of firearms, as shown in the chart above, were taken straight from the company’s 2010 10-K. Non-firearms sales were $18.6 million, $22.0 million and $19.7 million in 2010, 2009, and 2008, respectively. Based on these three years of historical revenues, I estimated it at $20 million. Sales for the perimeter security division are based on the CEO’s comments at CL King’s 8th Annual Best Ideas Conference 2010 where he said that Universal Safety Response (Perimeter Security Division) is going to generate $75 million in revenues this year.

Assuming that the net profit margin is 6 percent, these sales translate into $24 million of net income. Currently, the company’s net profit margin is higher than 6 percent, but I wanted to be conservative. If you assume that the company is not going to grow in the future and apply a conservative multiple of 10, then you get a value of $240 million. Today, the market capitalization of Smith and Wesson is around $215 million, which is about a 10 percent discount-to-value.

However, based on the fact that the current management has a successful track record of growing revenues and profits over the last several years, it is highly likely that it can achieve more growth in the future. Golden believes that within three to five years, Smith and Wesson will be generating $650 million in revenues. He is planning on doing this by expanding the consumer, military, and law enforcement businesses. Also, he believes that the perimeter security division is only in its infancy. Universal Safety Response is a new company that has only been generating revenues for about four years. Last year, it produced $54 million in sales, and this year, it is on track to produce $75 million in sales. Up until its acquisition, Universal Safety Response did not have the infrastructure to be a big business generating several hundred million dollars in revenues. Currently, Smith and Wesson is investing in Universal Safety Response’s infrastructure so that it can become a big business.

Based on these comments, I reconstructed an income statement that Smith and Wesson might have in three to five years.

Revenues
Revolvers$91,342,556
Pistols$143,190,688
Hunting Rifles$29,480,436
Tactical Rifles$73,701,089
Black Powder Rifles$22,227,313
Total Firearms$359,942,082
Non-Firearms$20,000,000
Perimeter Security Division$270,000,000
Total Revenues$649,942,082
Net Profit Margin6.00%
Net Income$38,996,525
I grew the sale of firearms at 4 percent per year for four years, and this is based on 2008 reports by the U.S. Bureau of Alcohol, Tobacco, Firearms and Explosives, which stated that the U.S. firearm manufacturing industry has grown at a compound annual growth rate in units of 4.6 percent from 2003 through 2008. I chose 4.0 percent versus 4.6 percent just to be more conservative. I left the sales of non-firearms unchanged.

Notice that I projected a significant increase in the sales of the perimeter security division from $75 million to $270 million. This is one of the ways I see that the company will be able to achieve its goal of $650 million in three to five years. Is $270 million possible? I think it might be achievable because as the CEO mentioned, Smith and Wesson is making infrastructure investments in Universal Safety Response so that it can achieve these revenues. Plus, Universal Safety Response did not even expand internationally and with the Smith and Wesson brand name, it shouldn’t have too much trouble doing so.

Assuming that the company can actually generate $650 million in revenues, this could easily translate into $39 million of net income using a conservative 6 percent net profit margin. If you apply a multiple of only 10, you get a value of $390 million. Remember, today the market capitalization is $215 million. But, you and I know very well that if any company is able to grow this much and has a bright future beyond three to five years, the multiple is likely to be much higher than 10. If we put it at 15, then you get a value of $585 million in three to five years. Assuming it all happens according to plan, you can more than double your money within this time period. If you don’t believe that it can grow this much, then you shouldn’t worry because you are not really paying for this growth. As I mentioned in the previous value calculation, if you assume no growth, the company is worth $240 million, which is less than the current market capitalization.

Conclusion

Smith and Wesson is a company that possesses a wonderful brand name that can be leveraged to enter other similar businesses. Over the years, the company was mismanaged until late 2004 when a new CEO was hired to turn it around. So far, he has been doing a good job except the company took a bullet when he acquired Thompson/Center Arms for $102 million. Today, it appears that the company is ready for growth again, and it is priced cheaply in comparison to its intrinsic value.

Disclosure: The Author does not own SWHC

About the author:

Mariusz Skonieczny
Mariusz Skonieczny is the founder and president of Classic Value Investors, an investment management firm. He is also the editor of Ultimate Value Finder, a monthly newsletter that features three underfollowed, unknown, and undervalued companies ignored by Wall Street.

Visit Mariusz Skonieczny's Website


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