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Smith & Wesson Holding Corporation (NASDAQ:SWHC)

F2Q09 Earnings Call

December 15, 2008 5:00 pm ET

Executives

Liz Sharp – Vice President, Investor Relations

Michael F. Golden – President and Chief Executive Officer

William F. Spengler - Chief Financial Officer

Analysts

Reed Anderson - D. A. Davidson & Co.

Chris Krueger - Northland Securities

Cai von Rumohr - Cowen and Company

Eric Would - Merriman Curhan Ford & Co.

Operator

Welcome to the second quarter fiscal 2009 Smith & Wesson Holdings Corporation earnings conference call. My name is Melanie and I will be your coordinator today. (Operator instructions) As a reminder, today’s call is being recorded for replay purposes. I would like to turn the call over to Ms. Liz Sharp, Vice President of Investor Relations.

Liz Sharp

Thank you, and good afternoon. Before we begin the formal part of our presentation, let me tell you that what we are about to say, as well as any questions we may answer, could contain predictions, estimates, and other forward-looking statements. Our use of words like project, estimate, forecast, and other similar expressions is intended to identify those forward-looking statements. Any forward-looking statements that we might make represent our current judgment on what the future holds. As such, those statements are subject to a variety of risks and uncertainties. Important risk factors and other considerations that could cause our actual results to be materially different are described in our securities filings including our forms F3, 10-K, and 10-Q. I encourage you to review those documents.

A replay of this call can be found on our website later today at www.smith-wesson.com.

This conference contains time-sensitive information that is accurate only as of the time hereof. If any portion of this presentation is rebroadcast, retransmitted, or redistributed at a later date, we will not be reviewing or updating the material content herein. Our actual results could differ materially from these statements.

Our speakers on today’s call are Mike Golden, President and CEO, and Bill Spengler, Executive Vice President and Chief Financial Officer. And with that I’ll turn the call over to Mike.

Michael F. Golden

Thanks everyone for joining us. Second quarter delivered mixed results, some very exciting, and some obviously very disappointing. It was a stark contrast between strong, solid performance in parts of our handgun and tactical rifle products, offset by very tough, ongoing challenges in the hunting business.

Today, Bill will provide a detailed financial analysis of the quarter, but first I will address each part of our business. I will review our performance in key areas, what we are doing to address current challenges, and why believe that despite the challenges that we, and all businesses, fact today, our strategy, and our structure position us well for the future. With that, let’s begin.

Our handgun and tactical rifle categories continued to deliver positive results in the second quarter. It is especially important to realize that these product lines have delivered positive results consistently over the past several quarters, despite the fact that we now appear to have been in a recession for nearly a year.

Piston sales of $18.5 million reflected growth in the quarter of over 40% versus the prior year. Within that category sales of our Sigma piston line grew by 77% in the second quarter versus a year ago. The Sigma is a well-positioned product that is performing well in the consumer market place, both for sports shooting and for self-defense.

Sales of our M&P pistols grew nearly 45% year-over-year. And here I want to make a couple of important points. First, those M&P results contain our first shipments into Iraq for distribution to the Iraqi military and security forces. We believe that order indicates that we continue to maintain a high degree of positive visibility with the Defense Department, boding well for future orders.

Second, our 45% growth also reflects our ongoing success in selling M&P polymer pistols into law enforcement agencies. The M&P continues to win at a rate of over 80% in agencies where we compete. In that total are some recent notable departments that have converted to the M&P pistols, such as Columbus, Georgia, Police Department, and the Texas Department of Criminal Justice.

In addition to the traction we have been getting in law enforcement, retail sales of our M&P pistols for the second quarter were up 17%.

Revolvers also continue to show positive signs. Although revolver revenue of $13.7 million was slightly lower than revolver revenue from the second quarter a year ago, last year’s numbers included a $1.6 million order for the Japanese Police. In fact, domestic revolver sales in the quarter actually grew by 13%.

Tactical rifle sales of $8.7 million in the second quarter were even more remarkable, showing a 308% growth versus the same quarter a year ago. We believe that our success in tactical rifles is based on a number of factors, not the least of these is the quality and accuracy that this rifle achieves by virtue of our rifle barrels, built using a technology we acquired with the purchase of Thompson/Center Arms.

While this growth was largely driven by strong adoption in the consumer market, we continue to drive growth from the law enforcement as well. We continue to penetrate law enforcement agencies at both the municipal and state level. So far there are 204 agencies that have selected our M&P 15 and it is winning at an impressive rate of over 90% in departments where it competes.

With regard to our tactical rifle and pistol results, bear in mind that today we are only reporting the quarter than ended October 31, 2008, so our second quarter sales don’t reflect the bulk of the surge in retail sales volume that began in early November and we have all read about in the media. But more about that later.

It is clear that the high points of our second quarter relate to the solid traction that we have maintained in the handgun and tactical rifle markets and the strong growth these categories have consistently delivered, despite the economic environment. Unfortunately, that environment, combined with a number of other factors, did take a severe toll on our hunting business, and as a consequence, our results in this category were very disappointing.

Hunting rifle sales of $11.5 million in the second quarter showed a 41% decline from the same quarter one year ago. This category continues to be affected by its inclusion in the consumer discretionary market place and a distribution channel that is buying cautiously and still suffering the extended effects of an inventory correction.

The reduced revenue in our hunting category in the second quarter negatively impacted gross margins in that business and negatively impacted our overall corporate results. Because of those results, and based upon a detailed analysis we conducted in cooperation with outside valuation experts and our auditors, we have taken a non-cash charge in the second quarter to reflect the impairment of goodwill and intangible assets of Thompson/Center Arms.

As Bill takes you through the detail of that charge and our second quarter results, it will be very clear that the hunting business has significantly had a negative impact on the otherwise positive results we delivered in the remainder of the business.

Because of the magnitude of that impact, I want to explain clearly how we think about Thompson/Center Arms and our plans for its future. As we conducted our recent review of Thompson/Center we realized that the economy, and therefore the hunting rifle market, remains uncertain for the foreseeable future. In addition, we acknowledge that the burden this business places on the balance of our company is sizeable and if left unaddressed, would continue.

As a result, we took a hard look at all of our options. These options ranged from reducing costs in our Thompson/Center Rochester facility to various forms of consolidating Thompson/Center support functions, and/or production, into our other facilities. We also considered relocating only the most profitable and best performing SKUs to Springfield, and finally, we considered a liquidation or a sale of the Thompson/Center business unit.

That analysis ultimate led us to the conclusion that maintaining the Thompson/Center facility, while reducing costs and also consolidating some of the support functions, is the optional choice for the business at this time.

Let me explain why. First, we attribute a portion of the success we are experiencing in tactical rifles to the quality and accuracy of our barrels, and those barrels are a direct result of acquiring the Thompson/Center barrel manufacturing expertise.

Second, by possessing internal high quality barrel manufacturing as a core competence, Smith & Wesson is a recognized rifle maker in the eyes of consumers, law enforcement, and particularly in Washington and with the U.S. military.

This is very important, since we know that the sole source contract for the M4 rifle currently used by the military expires in 2009. We think that our ability to manufacture, entirely in the United States, a state-of-the-art high performance tactical rifle will position us well as the military weighs its options next year.

Disrupting barrel-manufacturing operations in the near term, therefore, did not seem to be a reasonable choice.

Lastly, recall that the market for hunting rifles and a healthy economy, similar to that which existed when we purchased Thompson/Center Arms, is relatively large. At that time, Thompson/Center was profitable, taking market share in black-powder rifles, and enjoying a reputation as one of the mostly highly respected, high-end hunting rifle producers in the market place.

It continues to enjoy that same reputation but in fact, it is precisely the high price point, niche market, black-powder products that position Thompson/Center as one of the most discretionary product lines in what is already a generally discretionary category.

We believe it is this position that has caused our revenues to be more impacted than others in the hunting category, however, we also believe that we can expand Thompson/Center’s addressable market with new, lower price-point, yet profitable, products that we will begin to introduce in 2009.

So we will continue to take costs out of Thompson/Center while we expand the addressable market for our hunting products. As we move into the future, we will continue to revisit our analysis, assessing the recovery in the markets, traction of the new hunting rifle products, the ongoing performance of our tactical rifles, developments with the M4 military opportunity, and the health of the balance of our business.

Should these elements change, we reserve the right to change our plans accordingly and immediately.

With that, I want to turn the call over to Bill for a more detailed financial discussion. When he is finished I will return with some comments and we will go to questions from our analysts.

William F. Spengler

Total company sales for the second quarter were $72.7 million, a $2.0 million, or 2.8%, increase over the three months ended October 31, 2007. Within that, sales of all firearms totaled $67.5 million, an increase of $1.7 million, or 2.6%, over the second quarter of last year.

The balance of revenue, largely handcuffs and non-firearms accessories, totaled $5.2 million and grew by $225,000, or 4.5%.

As Mike commented, results in our sales of firearms were mixed, with strength in some categories and continued weakness in others, specifically those related to hunting. Handgun sales totaled $43.6 million, an increase of 11.6% over the year-ago quarter. Tactical rifle sales of $8.7 million represent an increase of 308% year-over-year and hunting rifle revenue totaled $11.5 million, a decrease of 41% on a year-over-year basis.

Gross profit for the second quarter of fiscal 2009 was $20.0 million, or 27.3% of revenue, as compared with $23.1 million, or 32.3% of revenue, for the second quarter of fiscal 2008. This represents a deterioration of 5% in terms of gross margin percentage from the year-ago quarter.

Approximately 60% of this gross margin erosion was caused by continued weakness in the hunting market where lower sales volume led to reduction in production levels resulting in lower fixed overhead absorption at our Thompson/Center facility.

In the face of weak demand we implemented a series of consumer promotions on our hunting guns, which further eroded gross margins. Finally, we did experience a shift in sales from high-end hunting rifles to lower-prices hunting rifles, resulting in further margin erosion.

The other significant contributor to our margin erosion versus the prior year continues to be our consumer and to a lesser extent, distributor promotions, in the handgun and tactical rifle categories. These promotions totaled approximately $1.4 million for the quarter versus essentially nothing in the same period during fiscal 2008.

As you may recall, our promotional activity really began to increase during the third fiscal quarter of last year. Promotional spending on handguns eroded the overall company gross margin by approximately 1.8 points, therefore accounting for most of the remaining 40% of the erosion.

I will now move to operating expense and income. I want to point out that for the moment I am going to discuss these items excluding the non-cash impairment charge, allowing s to compare year-over-year performance more clearly. I will then, separately, address the impairment impact.

Total operating expense increased over the prior year by $708,000, or 4.3%, in the second quarter of fiscal 2009. This increase was driven by a combination of factors, including increased compensation expense, partly driven by inflation, the filling of some operating positions, higher net stock option expense, along with some increase in our bad debt provision and higher professional fees.

As a result, and largely due to the gross profit results, operating income was $2.7 million in the second quarter, a 58.5% decline from the same quarter a year ago.

Other expense totaled $927,000 in the second quarter compared to other income of $213,000 last year. This expense is comprised almost entirely of an unfavorable, non-cash mark to market adjustment related to Euro foreign exchange contracts used to protect our purchases of inventory from Walther.

Interest expense of $1.4 million decreased by $669,000 compared with the year-ago quarter. The pay-off and retirement of our acquisition line of credit in the first quarter is now fully reading through in reduced interest expense as the remaining debt origination fees were written off last quarter.

Net income, excluding the impairment, for the second quarter of fiscal 2009 was $245,000, or $0.01 per fully diluted share, compared with net income of $2.9 million, or $0.07 per fully diluted share, in the prior year.

This result versus the prior year is largely attributable to the performance of our hunting business, which I would like to clarify. Thompson/Center is not a separate reportable business segment in the context of SFAS 131. We have, however, separately analyzed the Thompson/Center business unit, a process which involved some degree of operating expense and inter-company profit allocation, so to develop visibility into performance.

In summary, the Thompson/Center revenue in total, and here I am including all Thompson/Center activities, such as accessory revenue and revenue generated by the foundry, declined by 32% versus last year, from $25.3 million in fiscal 2008 to $17.2 million in fiscal 2009.

Thompson/Center gross profit declined even more dramatically, from $9.1 million last year to $4.2 million in the current quarter, a 54% reduction, driven by mix, promotional expense, and most importantly, the lack of overhead absorption. Although we implemented an 80-person reduction in force during the second quarter in Rochester, this only occurred in late September and therefore did not significantly impact on our second quarter results. The 80-person reduction in force follows a 56-person reduction enacted during the first quarter.

Operating expenses at Thompson essentially remained flat at $5.3 million. Estimated operating income for Thompson/Center under this analysis was therefore a loss of $1.1 million versus income of $3.9 million in the prior year, a $5.0 million swing.

It is clear that a separate Thompson/Center business unit analysis revealed a significantly unfavorable impact on the total company operating income.

The improvement in operating income of our non-hunting business, which makes up the majority of our business, was therefore masked by the impact of the hunting business, resulting in a 58% decline in total company performance. This same dampening effect obviously occurred at the revenue and gross profit lines.

Turning now to the impairment charge, intangible asset valuations are generally reviewed on an annual basis unless there is a reason to believe that evaluation is required in an interim period. Accounting standards, specifically SFAS 142, outlines several reasons that would lead a company to perform an interim valuation. One such reason is a significant change in the performance of a business unit or the environment in which a business unit is operating, and here I am paraphrasing.

For the reasons I have explained, in the second quarter it became appropriate for us to review our book value of assets originating from the purchase of Thompson/Center Arms. As such, we were required to review the fair value of our intangible assets related to this purchase, under SFAS 144 and SFAS 142 accounting standards.

We engaged outside valuation experts and we also worked together with our auditors in making this assessment. The result of this exercise is a non-cash net impairment charge of $76.5 million in the current quarter. This action reduces goodwill to a value of $0.0 and other intangibles to a new value of $5.5 million from $62.8 million.

It should be noted that there was no obvious market-based benchmark, such as any sort of comparable transaction, available to us in determining this valuation. Therefore, we relied on cash flow forecasting for the hunting-related business, based upon the best assumptions available to us at this time.

The effects of this impairment analysis are recorded in two locations in our income statement. A total amount of $98.2 million is shown in the operating expense category as its own line item and this is the full effect of writing down goodwill and the other intangibles. There is also an offsetting tax effect, adjusting the deferred tax provision, in the amount of $21.8 million, which appears on the income tax benefit line.

As a result of the non-cash impairment charge, positive second quarter earnings of $0.01 per fully dilute share were reduced to a loss per fully diluted share to $(1.62) under U.S. GAAP. Going forward, the amortization of intangible assets related to the T/CA purchase will now decline from $4.3 million to approximately $600,000 annually, a net expense reduction of $3.7 million annualized for a $2.3 million annual favorable effect on our after-tax earnings.

Now let me turn to the balance sheet. Accounts receivable decreased to $51.0 million versus $54.0 million at year-end and versus $61.0 million in the last sequential quarter. As anticipated, we collected a large amount of the remaining receivables, that had resulted from the dating terms typically provided in the hunting business, earlier in the year.

Inventories were $53.9 million at the end of the second quarter, a $6.8 million increase over last fiscal year end, and a $1.3 million increase over the first quarter of this fiscal year.

Actions have been and will be further implemented in the third and fourth quarters to reduce this carrying value. And I will discuss these in a moment when I comment on the third quarter.

Year-to-date capital expenditures were $3.0 million compared to $8.7 million last year. We expect to spend approximately $8.0 million on capital expenditures in fiscal 2009 versus $14.0 million in fiscal 2008. Major capex in fiscal 2009 will focus on improving production efficiencies, new product offerings, and various projects to selectively increase capacity and upgrade manufacturing technology.

Now to conclude on the current quarter with a look at cash flow and liquidity, as I discussed last quarter we have begun to augment our financial discussion with a new metric, adjusted EBITDAS, or earnings before interest, taxes, depreciation, amortization, and stock-based compensation expense. This measure will also eliminate non-cash one-time charges, such as the impairment or the mark to market adjustments on foreign exchange forward contracts that we have discussed today.

Moreover, it will provide you with a basis on which to continue to evaluate the cash-generating capacity and general liquidity of our business in the context of our bank covenants. Although I will not be providing you each quarter with specific results relative to each of the covenant terms under various debt instruments, the EBITDAS metric will nevertheless provide you with much improved visibility into where we stand.

Adjusted EBITDAS in the second quarter was $6.6 million compared to $11.4 million in the second quarter of fiscal 2008. On a year-to-date basis, adjusted EBITDAS was $16.8 million versus $24.8 million in the first six months of fiscal 2008. The presentation that is included in our earnings release clearly shows how this information has been derived.

Next, in November we obtained a modification in the required leverage ratio, from 3.0x to 3.25x, for the second and third quarter from our revolving line of credit lender, TD Bank. We undertook this due to what we viewed as a remote, but possible, near-term exposure, given the original 3x EBITDAS covenant leverage ratio and the near-term performance of our hunting product lines.

I am pleased to report that our business actually performed below the original 3.0x benchmark and we, therefore, would have more than met the original loan terms. In the end, this modification was prudent but ultimately unnecessary in the quarter and I personally appreciate the responsiveness of our bank.

Lastly on liquidity, I would note that our draw on the revolving line of credit reduced from $7.0 million at the end of the last fiscal quarter to only $1.3 million at the end of the second fiscal quarter.

Now let me conclude by spending a few moments on our near-term strategy, particularly as it would relate to the third quarter.

As is clear from the discussion so far, our hunting business unit has recently proven to be a drain on total Smith & Wesson company results. Although we appropriately do not report this as a separate business segment, we are internally focused on the earnings and the cash flow effects that it has on Smith & Wesson overall.

As a result we have been reviewing the cost structure of both the manufacturing and the operating expense level. We eliminated 136 positions at our Thompson/Center facility during the first half of the fiscal year and we have held year-on-year operating expenses in check.

However, we are taking further action to reduce costs and to reduce the inventory base at Thompson/Center and in the company as a whole. We have just concluded a one-week closure of our Rochester, New Hampshire, plant, over Thanksgiving, and we have added three incremental days to the Christmas shut down for all of our manufacturing facilities, so those holiday closures will now span two full weeks.

We also plan further cost reductions in the third and fourth quarters. These actions will prove important to cash flow as they will allow us to control inventory levels in a manner that is most cash conserving. We anticipate between a $4.0 million and $8.0 million inventory reductions for the total company in the third quarter results versus those in the second quarter.

Interim plant closures such as those during the third quarter will, at the same time, heighten absorption issues, particularly at Thompson/Center, such as those I have discussed throughout my review of the second quarter. Such actions, should they prove necessary in the fourth quarter, will do the same.

This represents appropriate cash and business management but does not help EPS in the near term. My point here is cautionary. Our third quarter will indeed by aided by the strong handgun and tactical rifle trends in the quarter. Translation of these trends into EPS results, however, will be greatly reduced in the third quarter by the actions I have outlined above.

Without providing a specific time frame, once we have lowered costs in our hunting business and inventory has been appropriately been brought lower than current levels, we believe that the strength in both EPS performance and cash flow generation that is being exhibited by the majority of Smith & Wesson’s business, will begin to read through the numbers with clarity.

Our strategy is to lower the cost base of Thompson/Center, minimize its negative impact in terms of EPS and cash, and in turn, limit the amount of borrowings we require. Again, the actions we have taken in this regard will unfavorably impact third and potentially fourth quarter earnings, offsetting gains in our handgun and tactical rifle business.

Throughout the coming months we will continue to evaluate the performance of our Thompson/Center Arms business in light of the various strategic options that Mike has outlined.

It will be important that we make each decision not vis-à-vis Thompson/Center alone, but as Mike indicated, within the context of the entire Smith & Wesson organization and its future opportunities.

That concludes my comments, so I will turn the call back over to Mike.

Michael F. Golden

Before I close, I would like to make just a few more comments. With regard to military opportunities, at this point in time we do not have any new information to share with you on the U.S. Air Force solicitation to replace their M9 pistol with a new, modern 45-caliber pistol. From what we know, this initiative is still listed as an unfunded requirement within their budget.

On the rifle side, efforts to review the military rifles seem to be gaining traction as the Army is moving forward to review the M4 rifle and determine if there is a need to pursue an upgrade. In fact, we were invited, and attended, an industry day with the Army last month where we shared our design ideas and how to enhance and improve the current M4 carbine platform.

We expect the Army to issue a request for information to the industry next spring that could lead to a rifle solicitation later next year.

On the consumer side, many of you have seen the media reports on the surge in gun sales, as indicated by the NICS background check data. For those of you who don’t know, those background checks were up 45% in the month of November, an historical record.

At Smith & Wesson are certainly seeing the benefit. It is important to note that the bulk of the surge did not begin until just after the election and is largely not reflected in the revenue gains for the quarter we are reporting.

From our perspective, the surge is effecting handguns and tactical rifles and our weekly read on distributor inventories indicates that these shipments are flowing immediately through to retailers. I want to point out that there is no way to know how long this surge will last. But for at least the short term, this growth in orders and shipments will help offset some of the costs we will incur as we take the proper steps to lower our inventories and costs.

In closing, I want to make sure I have left you with a couple of key points today. First, we have a strong, robust business in handguns and tactical rifles. Not only is that business delivering growth results today, but it has been doing so consistently throughout the last several quarters.

Second, we currently face significant challenges in our hunting business. Despite this, and the large impairment we took in the second quarter, we believe for a number of strategic reasons that keeping the Thompson/Center business unit in our company is the right thing to do at this time.

We will continue to revisit that decision and we reserve the right to make any changes in our strategy as circumstances evolve.

With that I would like to open the call now for questions from our analysts.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Reed Anderson - D. A. Davidson & Co.

Reed Anderson - D. A. Davidson & Co.

First of all, nice job on the sales, particularly in the M&P and the tactical. Curious on the promotional environment. Obviously you were promotional but it seems like the demand is there right now. To what extent does your outlook today continue to bake in assumptions that promotional activity is going to be here for the next couple of quarters?

Michael F. Golden

That’s a good question. And just to kind of refresh everyone, last year in the third quarter was when we began the aggressive consumer promotions to help stimulate the business and move product through the channels, so we’re just really anniversarying, in the current quarter, those changes.

We have some rebate promotions in place that ago through the end of December. They were put in place earlier this summer based on what we were seeing in the business. So they were in place prior to what we’re calling this retail surge that we are seeing.

At this point in time, we are not expecting to continue those rebates after December 31,2008. And we will see how things go and kind of react off of the market. But certainly with the retail environment that we’re seeing today, if it continues through the first half of next year, we don’t see that as necessary.

Reed Anderson - D. A. Davidson & Co.

And on a related note, you also had commented in your prepared remarks that Sigma was very strong, I think you said 77% up.

Michael F. Golden

Yes, yes.

Reed Anderson - D. A. Davidson & Co.

Should we read that to mean that, because that’s a little bit lower price point, is that partly a trade down, do you think, or do you think that’s just a function of the promotions you’re running? How would you read that?

Michael F. Golden

The Sigma product has got kind of a unique position. It’s a very good product at a lower price point. It’s out there. And certainly the economic environment is driving people to certainly look at how they’re spending money and what they’re spending it on. But don’t forget, the M&P did well, too, even prior to this surge. So but certainly the price point is affecting the Sigma sales.

Reed Anderson - D. A. Davidson & Co.

On the gross margin piece, from my expectation it is obviously a little disappointing in this quarter, given particularly where sales were. Your comment that at least in the third quarter and potentially in the fourth, you are going to have this absorption issue. Should we think it’s going to get even worse than the sequential trend we saw from Q1 to Q2 or just your thoughts on the order of magnitude.

William F. Spengler

Without heading too far down the path on guidance, one way to look on it is that Q2 still has hunting season effects in it for Thompson. And Q3, then we’re out of season. As you have lower revenue you have worse absorption, irrespective of the actions that were taken.

Reed Anderson - D. A. Davidson & Co.

It’s still a factor but it’s not the meat and potatoes of your hunting business, is what you’re saying basically?

William F. Spengler

That’s true.

Reed Anderson - D. A. Davidson & Co.

I just wanted to clarify, you had said that the savings you would pick up because you have basically gotten rid of the intangible piece that you’re amortizing off, that amounts to, on an after-tax basis, $2.3 million per year?

William F. Spengler

Annually, yes.

Operator

Your next question comes from Chris Krueger - Northland Securities.

Chris Krueger - Northland Securities

Based on your own Smith & Wesson records, and your own work you have done with your customers, going back to the 90s and the early months or quarters of the Clinton administration, can you give us any kind of history lesson there? What happened? I know there wasn’t NICS data back then, but I am sure you have done some work on how that went at that time for sales at the retail level.

Michael F. Golden

I certainly will. And we have done research on this. And these are industry numbers on handguns. Back in the mid-90s there was a surge in firearm sales. I think that’s what you’re talking about. And it was a pretty interesting phenomenon. The surge lasted about, ballpark, 18 months and the years after the surge there was a little bit of a dip but not much. It kind of came right back down to the trend line and just started back on the GDP growth level.

Now, circumstances, are they different today? We’ve got a pretty severe recession going on. That’s hard to guess.

But that’s kind of what history would say, is that the surge lasted for a while and you saw a little bit of a dip as you went back and it kind of stayed at a little bit of a lower level, but not significant.

Chris Krueger - Northland Securities

For our tactical rifles, obviously you had another great quarter there. I think, doing the math, you did about $8.6 million in sales?

Michael F. Golden

That sounds about right.

Chris Krueger - Northland Securities

As far as your capacity and all that goes, if you sell them as quick as you can make them, is that a kind of maximum level, $8.0 million to $9.0 million range? Or what would you say there, in a quarter?

Michael F. Golden

We don’t give capacity numbers out. But certainly the current surge is impacting tactical rifles and because we manufacture it internally, we have some control. Some parts come from the outside, we’re working with suppliers to try to increase the product of. But the real surge, as I said, did not have a significant impact on Q2, it really started hitting the full impact in Q3.

Chris Krueger - Northland Securities

That included tactical as well?

Michael F. Golden

Yes.

Operator

Your next question comes from Cai von Rumohr - Cowen and Company.

Cai von Rumohr - Cowen and Company

Good work on the cash flow. Could you give us a little more color sort of by market channel, approximately the sales comparing law enforcement, fed military, and international year-over-year?

Michael F. Golden

How we did year-over-year in the quarter?

Cai von Rumohr - Cowen and Company

Yes.

Michael F. Golden

The consume channel for Smith &Wesson product was up, in the quarter, about 35%. Law enforcement was up about 20%. Our international business was actually down a little bit. As I mentioned to you, we had that Japan order that was in there last year.

Cai von Rumohr - Cowen and Company

And fed military?

Michael F. Golden

Federal government was down 9% but it’s small numbers.

Cai von Rumohr - Cowen and Company

And where do you think you are in terms of the channel, in terms of inventory? That was a problem going into the hunting season. Do you feel that’s been pretty well cleared out or is that still an issue?

Michael F. Golden

I think you guys know, we work closely with our distributors and we do look at their inventory on a weekly basis. Certainly this retail surge has had a pretty significant impact on distributors’ inventory where to say it’s not an issue anymore is probably an understatement. There still is some hunting product out there. In fact, this focus on tactical rifles at retail and handguns has really had a corresponding negative effect on people spending money on hunting products because the surge is on handguns and tactical rifles, like I said. But distributors’ inventories, the product is selling right through distributors right out to retailers as quick as they get it.

Cai von Rumohr - Cowen and Company

So that’s in the handguns and the tactical rifles. But on the hunting product, is that pretty well skinnied back or is that still an overhang?

Michael F. Golden

It certainly has come down since last year. It is certainly not the problem that it was. But there are still some pockets that it’s working through.

Cai von Rumohr - Cowen and Company

You’re talking a pretty impressive decline in the inventories in the third quarter. Because last year, as I recall, the inventories were just flattish. So if in fact, if you come down $4.0 million to $8.0 million, is that what you said?

William F. Spengler

Yes, we said $4.0 million to $8.0 million off the balance at the end of Q2.

Cai von Rumohr - Cowen and Company

So if we come down to $49.0 million we are going to be at a little under 17% of sales, or maybe even less, depending on where those sales are. What is the right number? Should we expect, hopefully then, that inventories go down again in the fourth quarter, which is a good quarter for handguns, or what should we look for?

William F. Spengler

Without putting the same kind of clarity on it we did with Q3, yes, we will again take actions in the fourth quarter to bring the inventory down again from the level we end up at Q3 with.

Cai von Rumohr - Cowen and Company

Any comp in terms of with these kinds of numbers, where the net debt can be? Is there a target for where you would like to have the net debt at the end of the third quarter?

William F. Spengler

Hopefully, we can pay down a little bit more on some of the smaller loans, but we’re really down now to not having a particularly large draw on the revolver. We’re sticking with, at this point, the $80.0 million in the convert and then we will bounce around with some level of draw on the revolver, based on working capital needs at the time, but that will be a narrow range.

So net debt, I don’t want to forecast it, but you start with $80.0 million and you shouldn’t be able to get over $100.0 million.

Cai von Rumohr - Cowen and Company

In this tougher time are you having any issues with receivables, folks paying or paying late? Has that been a problem?

William F. Spengler

Infrequent. Not really. But what we do do is we did bump up our reserve, just because of the general economic conditions, that our trade or segments of our trade are operating in.

Cai von Rumohr - Cowen and Company

How large was that increase in the reserve, approximately?

William F. Spengler

In the quarter I think we go up about $300,000. I don’t have the exact number in front of me. But if I recall, it’s about $340,000.

Michael F. Golden

Keep in mind that we, by and large, bill distributors. And their experience in this surge in retail, which is bringing cash into them, too.

William F. Spengler

The other thing I want to add is that is a bad debt provision. We really don’t have write-off experiences.

Cai von Rumohr - Cowen and Company

With what you are talking, the receivables in last year held relatively level in the January quarter then they go up a little bit in the fourth as the inventory comes down. Should we expect that kind of a pattern, which would suggest that hopefully the working capital comes down, in both the third and fourth quarter.

William F. Spengler

I think that pattern is not bad. Depending on where the revenue comes out in Q3, you could have some growth in receivables, particularly driven by the other-than-hunting-business segment, but it will be offset by a decline, because we will be in a lower-revenue period, really, on the hunting business.

We are also not altering, we are not varying, from normal terms. That’s not part of our promotional activity. And inventory should follow the trend we were discussing before.

Cai von Rumohr - Cowen and Company

How should we think as we’re doing our modeling on your handgun and tactical rifle business with converting NICS data into sales? I mean, like we’re up over 40% in November. On average, and I think it’s a fair question because we don’t know what December or January is going to be, but if it continues up 40% should we expect your sales to be up 40% or 20% to 30%? What’s the rough?

Michael F. Golden

Keep in mind, that becomes a little tricky. We use a number of factors to try to understand and forecast our business. NICS is only one of the factors that we look at. And remember, NICS is one number, they don’t break it between handguns or long guns, and used guns are in that number, also.

So we’re selling into distributors so there is an inventory buff that is out there. NICS is reflecting retail sales. We use it as one of the indicators of the trend, are people buying firearms, is what that basically tells us.

And certainly when you go from September, say business was up .08%, the NICS data, October was up about 15%, and then November up 45% is an indication that people are buying guns. But there are a lot of factors that go into the NICS data. So it’s one factor we use. Certainly an overall indicator, but you can’t draw a direct line.

Operator

Your next question comes from Eric Would - Merriman Curhan Ford & Co.

Eric Would - Merriman Curhan Ford & Co.

I think Cai asked a question about distributors and you responded saying your distributors are really selling this stuff through as fast as they can get it. Taking that a step further, what are seeing from distributors in terms of their propensity to order? Are they really kind of being very cautious with orders, ordering smaller amounts than they normally would, given the headaches of last year, or do they take a little more risk and maybe order more, kind of get more come through their doors? Less real time basis, more kind of taking some chances on future trends.

And then if we do get the surge continuing for some amount of time in the coming months and quarters, how would you say Smith & Wesson is positioned to handle that surge relative to other manufacturers that may not have the right products, may not have the manufacturing capacity, may not have the capital, however you want to position it.

Michael F. Golden

Right now, on distributors, and you talk to retailers and you hear the same thing that we hear and see from retailers, is as quick as the product is hitting the retail store, it’s gone out the door. On handguns and tactical rifles, again; not on hunting products.

So distributors are ordering, by my view, aggressively. But many of them have been around for a long time and they have experience of dealing with these surges so they are monitoring it as we are monitoring it, but they are ordering aggressively, as the product comes in and comes through.

No one knows how long this surge is going to last, so we’re not putting capital expenditures in place to increase capacity simply because of the surge. That would be a mistake, in our view.

But we think we are positioned to respond. Our manufacturing guys have built a fair amount of flexibility into our facility so it gives us an advantage to be able to shift the mix.

And some of our foreign competitors have a longer supply line back to the factories outside the United States than we have. Our guys are looking at it on a daily basis to make sure that we are adjusting our mix to meet with what the distributors are ordering.

But I would say by and large, through the channel, from the retailer end and the distributor end, they are taking a fairly aggressive stance on the categories that I mentioned where the product is selling through fairly well.

Operator

We have no further questions at this time.

Michael F. Golden

I want to thank each of our employees at Smith & Wesson and Thompson/Center for the hard work they have done this year. It has obviously been a difficult year. Together we want to wish all of you very happy holidays and a prosperous New Year. Thanks for joining us and we will see you again next quarter.

Operator

This concludes today’s conference call.

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Source: Smith & Wesson Holding Corporation F2Q09 (Qtr End 10/31/08) Earnings Call Transcript
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