The recent gun-related tragedies in the U.S., particularly the Newtown massacre in December 2012, has had a profound impact on the firearms industry. Putting politics aside on this issue, historically, in times of higher public interest in gun control legislation, sales and profits of these companies have soared. This is because gun enthusiasts are afraid of new laws being enacted that will restrict certain types of gun sales or will require more extensive or lengthy background checks.
These fears cause a rapid short-term increase in sales for gun companies. Smith & Wesson Holding Corporation (SWHC) is no stranger to these dynamics, and in the past six months the company has seen huge growth in both sales and margins. For the third quarter 2013 results reported in March, the company reported quarterly sales of $106 million to the consumer channel, which was an increase of 35% year over year. Gross margins also increased an impressive 600 basis points to above 36%.
Despite the recent financial success of the company, the headline risk in the industry with the fear of pending legislation has kept the stock price relatively flat and the P/E is now just over 9, which is very low for a company with this level of growth. On a relative basis the company is trading considerably cheaper than a major competitor, and seems to be beaten down unfairly. I think the stock is worth between $12 and $16 per share and could even double over the next year, assuming continued strong execution and a realization by the market that the risk of game-changing legislation is low.
Note: Unless otherwise noted, financials are sourced from the latest annual report or third quarter 2013 conference call.
Smith & Wesson-branded firearms have been around since 1852. Not many brand names can boast such a long, well-established reputation for quality. The major product categories include: handguns, Walther, modern sporting rifles, hunting firearms, and parts and accessories. Handguns are sold under the S&W and M&P brands. Walther firearms are imported and distributed from Carl Walther GmbH in Germany through an exclusive agreement which expires at the end of 2013. A separate manufacturing agreement expires at the end of fiscal 2015. The company has already stated that these agreements will not be renewed. Sporting rifles are sold under the M&P brand, and hunting firearms under the Thompson/Center brand. The breakdown in terms of sales as of the end of fiscal 2012 is as follows:
|Segment||Sales (m)||% of Sales|
|Modern Sporting Rifles||$75||18.2|
|Parts & Accessories||$21||5|
In terms of margins, the company has had relatively steady margins for more than a decade, which is a sign of a stable competitive advantage in the market. Gross margin has been between 29% - 32% for most of the decade, with the exception of the recent spike to 36%. Operating margins have been between 4% and 11%, with a recent spike to around 20%.
Recent Headline Risk in the industry
As stated above, S&W has seen recent growth well over 30%, as many would-be gun buyers have rushed to make purchases in fears of pending legislation. After all, anger from the Newtown massacre in December led many to believe that the U.S. Congress would come together to enact tougher gun control laws and also reinstate a ban on assault weapons. S&W’s stock is still down about 20% since Newtown. Now, nearly five months on, and not much has happened in terms of legislative changes. The U.S. Senate defeated the gun control bill, and that is before it even reached the Republican-controlled House of Representatives. Looking at how gridlocked the politics continues to be in Washington these days, I think the risk of any serious gun control legislation is very low. Even if assault weapons were to be banned again like they were under the Clinton Administration, this makes up less than 10% of the business of S&W and should not be seen as a major threat to the company.
Another development that has occurred is the general public distaste for the industry as a result of the increased appetite for gun control. This has lead to less demand for the stocks and certainly has contributed to downward pressure. For example, pension funds have been dumping the stocks the past few months.
The firearm industry seems to continue to always do well over the long term, despite short periods of headline risk. In the past decade many events have occurred having some impact on the industry, e.g., the great recession, the election of a Democrat to the White House, and several school shootings. However, through all of this, Smith & Wesson has still managed to grow revenues at a CAGR of more than 10%. In the most recent quarterly results, revenues were up more than 35% in the consumer channel. Interesting to note I think is that even in the professional sales channel, which includes law enforcement agencies and international sales, sales were up more than 50%. This only constitutes about $16 million, so much smaller than the $106 million from the consumer side, but it shows that the growth was strong in law enforcement as well, which is less impacted by the headline risks in the industry. The growth here was primarily attributed to the success of the M&P polymer pistol line which has continued to gain market share. Overall the company reported in its latest annual report that it had a market share of 18%, 5%, and 15% for the handgun, hunting firearms, and sporting rifle markets respectively. From 2005 to 2010, the U.S. Bureau of Alcohol, Tobacco, and Firearms reported a CAGR of 11% in unit growth of firearms sold. It is hard to predict the rate of growth going forward; however, with recent strong growth, and continued market share gains I wouldn’t be surprised to see a similar rate.
In the next year or so the growth will be offset somewhat by the loss in business from the Walther line, as this currently makes up almost 8% of sales but will be close to zero going forward after the termination of the distribution agreement. However, despite this negative, there are several positive factors which should contribute to further growth, including the huge sales backlog of $667 million. This is now greater than one year of sales, and the company stated very clearly on the recent conference call that fourth quarter estimates were based on capacity not demand, as it has been unable to add capacity fast enough to keep up with orders. It should be noted that a large percentage of this backlog might never translate to real sales, but even if only 50% of it materializes, it should still bode very well for near-term strength in revenues and earnings.
The CEO of Smith & Wesson Holding Corporation is James Debney. The 44-year-old joined the company in 2009 as president of the firearms division, and was promoted to CEO in September 2011. He currently owns less than 1% of outstanding shares. All insiders combined hold about 2% of the company. Debney was an industry outsider, having come to S&W from a background in plastics manufacturing from an Alcoa Inc. (NYSE:AA) unit. What he has brought to SWHC is an increased focus on product marketing to grow market share in underserved markets. The company was traditionally strong on engineering and known for product excellence, but seen as weaker on the marketing front. The current strategy to push M&P polymer pistols hard seems to be gaining momentum. This is evident by the recent 50% sales growth in the professional channel, including some recent big deals such as the San Antonio Police Department which ordered 2,600 M&P guns recently.
Although Debney does not have years of deep experience in this industry, his outsider credentials and marketing prowess don’t seem to be hurting the company. Although I don’t see any huge positives to be excited about here, I also don’t see any major negatives with executive management. Overall, the company has very loyal employees, with 22% of them having worked for 25 years or more at the company.
The balance sheet of SWHC is sound. The company has a debt to equity ratio of about 0.30, and has a debt balance of less than $50 million. The current ratio is almost 3, and the interest coverage ratio is more than 20. I don’t see any near term risks in terms of the balance sheet. During the most recent quarter the company purchased $20 million of stock, which is about 3% of the shares outstanding. That is an impressive amount in a short period, and shows that the company is ratcheting up buybacks at a time when the stock is undervalued.
Other than the current headline risk in the firearm industry due to potential new gun control legislation, there are a few other points to know about Smith & Wesson.
Heavy dependence of consumer sporting goods channel makes business cyclical.
The company is trying to increase law enforcement and military contracts over time, as sales in the professional channel are much more stable and less susceptible to legislative risks. To date the company does have contracts with more than 1,000 law enforcement agencies. However, it has not been able to get any major military contracts, which would be far more substantial. As a result, nearly 90% of sales are still to individual consumers and this makes the business unpredictable over the short term.
The recent sales boom has created a bubble that is ready to pop.
Many industry analysts have become wary of gun stocks because of the huge run-up in sales. Obviously, this growth momentum cannot continue forever, and is likely to slow considerably in the next year or two, and some industry pundits and analysts have stated that for this reason investors should stay away. Personally, I think this risk is not as big as its made out to be, simply because everyone is already expecting it to happen and it’s priced in. Trading well below historical averages with an EV/EBITDA of 4.5, the market clearly expects a near-term decrease in earnings from current levels. However, with long-term historical valuation averages of nearly double the current level, I think the stock has significant upside because earnings are not likely to fall that quickly, especially with a strong order backlog.
Over the past year, Smith & Wesson has gotten downright cheap on an EV/EBITDA basis, where it now trades at a multiple below five, the lowest in the past five years.
Interestingly, the stock has not dropped in this period. In fact it is trading higher today than it was one year ago, $8.86 per share vs. $7.65 a year ago. What has been happening is that sales and earnings have increased substantially the past six months, mostly after the Newtown massacre and with fear among gun buyers that increased gun restrictions will be put in place in the U.S. The market clearly does not think that this growth is sustainable, which is probably a good assumption, as not many companies maintain sales growth of 35% plus for very long. However, the question we have to ask ourselves is simply whether this very low multiple is fair, or whether Smith & Wesson has been unfairly punished by the market. Looking at a DCF valuation I think it is exceedingly difficult to make a good judgement on this based on cash flow growth alone, as the cyclical nature of the industry has proven in the past decade that EPS and FCF per share tend to fluctuate substantially. Full year EPS for 2013 is expected to be above $1.17, but looking at the company historically there is no telling where it will be the few years beyond that.
What I think is very useful here is to realize that the gun business seems to always prove itself quite resilient over the long term even in times of short-term troubles like the present. The bottom line is that revenues have increased more than 10% per year in the past decade, and the long-term prospects seem to be fine. The polarizing political nature of the gun debate will mean very minimal or incremental changes to laws and regulations, nothing too drastic will ever pass the U.S. Congress. I think from a valuation perspective, it’s most useful to compare Smith & Wesson relatively to competitors. Sturm, Ruger & Company (NYSE:RGR), the best, comparable, publicly-traded company, is trading well over seven times EBITDA. Interestingly, if you look at these two companies over the past five years, generally they trend close together on EBITDA multiples, and whenever SWHC has dipped lower, it typically bounces back:
This difference doesn’t seem to really make sense currently, as both companies have recently reported similar performance in terms of sales and earnings growth. Both also have long-standing brand names and competitive positions. A bounce back to eight times EBITDA for Smith & Wesson seems like a distinct possibility in the near term, which would be a share price of close to $16. Even if you take a more conservative view and assume that earnings fall quickly back to historical averages, fueled by a drop in consumer demand and helped by the pending loss of Walther sales, a multiple of six to seven times EBITDA would still be quite justifiable.
The Bottom Line
In summary, I think the shares of SWHC are fairly valued in the $12 - $16 range, and it wouldn’t be at all surprising to see the stock double in the coming year if some of the headline risks of stricter legislation turn out to be unfounded. Even considering the likely drop in sales and earnings from the current elevated levels the stock is likely to trend back towards historical multiples. If this doesn’t happen, I see minimal downside for the stock at the present time as much of the industry negativity is already well priced in. Therefore, I see an attractive risk/reward profile on Smith&Wesson, and the small cap seems like a good contrarian value play today.
Disclosure: I may initiate a long position in SWHC in the next 72 hours.