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You have to wonder whether it is the fear that Armageddon will occur in December as foretold by the Mayan calendar or just paranoia that the second Obama administration will seek broader gun control laws that has propelled sales for the small firearms manufacturer Smith & Wesson (SWHC). The 150-year old company has grown sales at the rate of 18.5% annualized over the past seven years and accelerated to more than 28% in the past year to $456.3 million. The share price has soared 239.31% in the past year alone.

I think the fear of tougher gun control laws may be overblown. This issue did not play prominently in the recent campaign and the types of additional controls mentioned, background checks, for example should not have a major impact.

INCOME STATEMENT

SWHC has a fiscal year ending April. Highlights from the first quarter 2013 are:

  1. Nets sales were up 48.3% year-over-year to $136.0 million
  2. Net income per diluted share from continuing operations were $0.28 as compared with $0.04 a year ago
  3. Gross profit for the quarter was 37.7% of sales compared with 28.9% in the prior year
  4. The operating margin was 23.0% compared with 6.0% year-over year
  5. Net margin expanded to 13.1% in F1Q13 0.9% in F1Q12.

The financials for F2Q13 are not released yet though the company has provided some guidance. It expects per share earnings of $0.23-$0.24 on net sales of $136.0 million, up from the previous guidance of $0.19-$0.21 on sales of $130 million to $135 million. The six analysts followed by Thomson Reuters Research now have a consensus of $0.24 for F2Q13 and $0.16 for the third quarter.

Looking further out, analysts are forecasting F13 sales in the $527.9 million to $543.0 million range with estimates averaging $537.94 million. The consensus is about 30.6% more than F12 sales of $412.0 million. For F14, estimates range from $526.5 million to $598.2 million and average $557.75 million.

The company is experiencing an expansion in margins. The gross margin for the trailing twelve months is up to 33.5% as compared with the five-year average of 31.0%. The operating margin is up sharply to 15.5% from the 3-year average of 9.1% or the 5-year average of 2.6%.

During the first quarter SWHC sold the assets of the discontinued operations for nearly $10.0 million.

(click to enlarge)

BALANCE SHEET

The company's cash position has remained fairly constant over the last several years. Cash has ranged from $52.5 million to $57.2 million, well above $39.9 million reported in 2010. At the same time, goodwill and intangible assets have dropped from a high of $100.1 million in 2010 to $4.4 million in F1Q13.

SWHC has been paying down debt. In 2010, long-term debt stood at $80.0 million and is now just $43.6 million. Long-term debt as a percentage of free cash is just 93.56% and just 36.9% of working capital. Interest coverage is a strong 9.6X. Long-term debt to total capital is 24.8% and long-term debt to equity is 33.0%.

CAPITAL ALLOCATION

For the trailing twelve months, the company generated about $46.6 million in free cash, well in excess of its needs. Hopefully, SWHC will start to return capital to shareholders. For now, the company is not paying a dividend. Of more concern to me is the fact that the company continues to dilute its shares. For the last twelve months, the company diluted shares by 1.3%. Since 2006, the company has issued diluted shares by 78.6%.

The seven-year growth rate for free cash is 34.2%. Unfortunately, free cash is erratic.

VALUE

The company's capital structure is solid. It has more cash than long-term debt and a current ratio of 2.5X. It has been doing a good job managing inventory relative to sales by bringing the inventory to sales ratio down to 13.8X from 15.1X in 2011.

The shares are trading at 15.1X TTM earnings and 10.9X estimated EPS. These multiples are below the broader market. The PEG ratio, using estimated EPS and the forecast EPS growth rate of 22.0% is a very low 0.5X.

The price-to-book ratio of 4.8 is high by any standard including the company's long-term average multiple. The market is pricing in high growth. At 1.41 sales, the PSR is also high for this company but not on a relative basis.

I find that valuation metrics based on enterprise often to be more informative than market price metrics. In this regard, we see that EV/EBITDA is 7.72X, a level that is low both on an absolute basis and relative to the industry median. On the other hand, EV/Free cash is 13.54X, which is high and EV/sales is 1.38.

Profitability, as well as expectations for earnings growth, may justify higher multiples. The analyst consensus 3-5 year EPS growth estimate is 22.0% in an environment where the economy is expected to grow 1.5%-2.5%.

SWHC returns 30.0% on equity and 40.18% on invested capital. Last fiscal year, ROIC was 19.8% and the five-year average is 0.70%. The company is dramatically increasing its profitability. To verify the quality of ROIC, I also consider the cash return on invested capital. On a TTM basis, SWHC has a cash return on invested capital of 26.52%. This is a very high rate of return. SWHC is also able to convert about 66% of its operating income to free cash.

SUMMARY

The share price of Smith & Wesson has run up more than 200% in the past year and 22% in the past three months. However, I think the company remains undervalued as long as it is able to maintain these high levels of returns on invested capital. The high end of the market vale estimate is $17.00. Based on the known facts, I think this is a realistic target. If the Mayan calendar is wrong, profits can be realized by investing in SWHC now.

Source: A Bullish Case For Smith & Wesson