Before we start this article, let it be known that the ideas and analysis presented here are neither for nor against the gun control argument. The basic concept of this write-up revolves around current firearms manufacturers and how their stocks may be impacted by the current events both in the media and on the political stage.
With the recent tragedy in Connecticut and other instances of mass shootings around the country, the topics of firearm violence and gun control have made their way front and center. Both pro and anti-gun groups clash daily as the debates spills out into the media and upon the political stage. Emotions run high as people on both sides of the issue plead their case as what should be done next. To add further fuel to the fire, politicians at the state, local, and national level have entered into the fray. Talk of sweeping executive orders and legislative decrees fan the flames of discontent on both sides of the issue.
Let's take a step back from this emotionally charged issue and look at it from the investor's point of view. Is there money to be made in the stocks of firearms/ammunitions manufactures? Or if one already has an investment in these companies, is it safe to remain in them? These are tough questions, but let's see if we can come up with some constructive ideas without getting pulled into the emotional quagmire that has much of the country paralyzed.
For any company, regardless of what it sells, demand for its product is the key to success. Fortunately for us it is rather easy to measure the demand for the guns in the firearm industry. The best way is via the National Instant Criminal Background Check System which is run by the FBI. This is the system the federal government uses to perform background investigations on gun buyers when guns are purchased from Federal Firearms License Dealers (FFLs). In December, 2,783,765 total background checks were carried out to purchase firearms, surpassing the previous record from November 2012 when 2,006,919 checks were performed.
Demand is high, but we should actually ignore these two numbers as outliers for now. These numbers were driven by the belief that sweeping changes were imminent, and certain products will become instantly banned. Instead let's look at the number over the last 2 years in the graph below.
It's not hard to see that the figures steadily increase over that time frame. Plain and simple, it seems that demand is here to stay.
Obviously the biggest risk to an investment in firearms revolves around the current political environment. With the federal government looking to use a mix of executive orders and Congressional legislation to enact gun control, it becomes very confusing. On top of that one finds individual states making their own statues, both pro and con. A prime example is the state of New York, which just passed sweeping gun control laws with strict mandates. Many gun owners in New York woke up to find what was legal to possess the day before, has now been banned under new legislation.
This type of uncertainty will play havoc with the equities of the gun companies. Trying to quantify the effects of this current political environment it not an easy thing to do. All investors really need to know is that nothing will kill demand for a product faster than governmental bans on that product.
This being the case, let's now turn our attention to Smith and Wesson (NASDAQ:SWHC). Does an investment in its stock make sense for investors?
Smith & Wesson Holding Corporation
When it comes to firearms, one of the biggest names in the business is Smith and Wesson. This company provides products and services for safety, security, protection, and sports in the United States and internationally. The company offers firearms, handguns, sporting rifles, hunting rifles, black powder firearms, handcuffs, and firearm-related products and accessories.
As we begin our analysis on SWHC, we find that the company has recently discontinued its turnkey perimeter security solutions unit. This was part of the company that was dedicated to selling products that protect and control access to key military, government, and corporate facilities. It seems that SWHC wanted to focus its attention on the firearms side of the house. This makes sense as the perimeter security solutions unit lost money for the company on a continual basis. On July 10, 2012, SWHC entered into an agreement with FutureNet Group, Inc. where it would acquire substantially all of the assets of the perimeter security solutions unit. The purchase price was $8.3 million. Since that time SWHC received $7.5 million in cash and recorded a receivable for the balance.
This means that Smith and Wesson is once again solely focused upon firearms, and business is booming. Net sales for the six months ended October 31, 2012 were $272.6 million, an increase of $88.5 million, over net sales of $184.0 million for the six months ended October 31, 2011. Income from continuing operations for the six months ended October 31, 2012 was $35.3 million, compared with income from continuing operations of $3.2 million for the six months ended October 31, 2011. Needless to say, these are some truly outstanding numbers.
Looking closer we see that SWHC has identified that increased demand for smaller sized pistols and its M&P branded polymer products resulted in higher net sales and gross margins. To simplify this, the smaller sized pistols could also be identified as the semi-auto handguns. The M&P (Military and Police) sporting lines are the AR-15 style rifles and semi-auto pistols that are front and center in the political arena. The company's hunting product sales have also increased from the prior year, but it is evident that the real growth is coming from the M&P sporting lines and smaller sized pistols. Consider the chart below from its third quarter SEC filing.
Here is the problem, if the Congress puts an "Assault Guns Weapons Ban" in place, it will have a profoundly negative impact on SWHC's modern sporting rifles sales figures. The current view right now is that the Assault Guns Weapons Ban legislation has little chance of being approved by Congress. Needless to say, that can change on a moment's notice based on many unforeseen events and backdoor dealings. Of course it would be anyone's guess as to what any new piece of legislation might entail. What one has to remember is that any new legislation's primary purpose would be to limit the access to certain type of rifles which are mostly represented in SWHC's M&P line. In the chart above that makes for about 22% of the net sales for the company. If legislation were to come into play that affected SWHC's semi-auto pistol sales, like what has occurred in New York, then that could further hurt the company's bottom line.
According to SWHC's financial statements, the handgun sales make up 53% of the total sales for the company. Now not all of those sales are related to semi-auto pistols as some are going to be classified as revolvers. For now the use and ownership of revolvers have not come into play on the political stage. The final results though would be devastating if any legislation against semi-auto pistols were to be put in place on top of the purposed "Assault Guns Weapons Ban".
For now the company looks financially sound. As of October 31, 2012, it had $61.3 million in cash and cash equivalents on hand. This included restricted cash of $3.3 million. It also has a $60.0 million revolving line of credit with no borrowings as of October 31, 2012.
One other item that investors must consider deals with the most recent surge in gun buying. From December 2012 through January 2013 the public has made a run on any gun that was deemed as an assault rifle. High capacity magazines, ammunition, and the rifles themselves were purchased at such a rate that the entire supply chain was exhausted. Much of this supply was purchased for the intent to resale at a later date. If no legislation makes its way into law, these rifles will eventually find their way back into the markets as used rifles. A flood of such rifles could easily drive prices down as there would be a glut of used but unfired firearms for sale. The final result for SWHC is that there would be reduction in demand for newly made M&P rifles until the glut made its way out of the supply chain.
The final analysis for SWHC is best summed up with the word uncertainty. With new legislation being introduced daily, it means that SWHC's future is in a state of limbo. That being the case I would not recommend buying any new shares of Smith and Wesson while this dark cloud still hangs over the company.
For those investors currently holding the stock, now might be the time to take any profits you might have. For those who wish to continue to hold shares in your account, I would suggest buying put options to hedge the massive amount of risk that currently exists.
For our next article we will focus on Ruger (NYSE:RGR) and see how this company might fare during these uncertain times.