Gun manufacturer Smith & Wesson (NASDAQ:SWHC) announced fantastic third quarter results, as demand outpaced supply. Revenue increased 39% year-over-year to $136 million, handily exceeding expectations. Earnings, adjusted to reflect continuing operations, more than tripled year-over-year to $0.26 per share, exceeding consensus estimates.
We're not surprised by the results, as other firms like Cabela's (NYSE:CAB) and Big 5 (NASDAQ:BGFV) reported that gun sales have surged in the wake of the Sandy Hook tragedy and fears of new gun regulations. The trend looks durable at this point, and with the general lack of compromise in Congress, we think it could take awhile for any new national gun legislation to surface.
On top of strong sales growth, Smith & Wesson was able to drive tremendous gross margin expansion, as the firm benefited from product mix and volume leverage. Gross margins were 620 basis points higher than a year ago at 36.8%. Although year-to-date gross margins are running well above previous levels, we think it is sustainable in the short term - as long as demand remains robust.
SG&A expenses rose on an absolute basis to $22.1 million, but fell as a percentage of sales to 16.2% from 20.2% in the same period of fiscal-year 2012. As a result, we saw tremendous operating margin expansion. In fact, operating margins nearly doubled to 20.6% of sales, which helped drive the firm's solid earnings expansion. Although the company had to invest in capacity expansion, the firm struggled to meet demand, leaving some sales on the table. The company's backlog was 43% higher than a year ago (an all-time high of $667.8 million), though management warned that a record high backlog may not be indicative of future sales, saying:
During the quarter, the backlog increased by $335.1 million. As I have said before, our backlog is not indicative of future sales, especially when it continues to exceed our manufacturing capacity. Since there was very little of our product in the channel, we believe that some firearm retailers have placed orders through our distributors that exceed their actual requirements. Thus, there is a very real possibility that these excess orders may have resulted in our distributors placing excess orders with us, thereby, potentially inflating our backlog. We have worked closely with our distributors to minimize this occurrence, but there is no way to know for sure whether or not there is excess in our backlog.
Nevertheless, free cash flow was terrific during the quarter, coming in at $20.4 million. As a result, the firm authorized an additional $35 million worth of share repurchases on top of the $20 million worth of stock the company repurchased during the third quarter of fiscal-year 2013. Although we think shares look fairly valued, management is clearly signaling that it believes the stock is cheap.
Looking ahead, the company anticipates revenue to grow 40% year-over-year to $575 million to $580 million, driving operating earnings per share to $1.17-$1.19 per share (a tremendous increase from the $0.40 per share it earned in fiscal-year 2012). Fundamentals look fantastic for fiscal-year 2013, and we think fundamentals will remain strong heading into fiscal-year 2014. The risk remains that some sort of event will occur that could damage gun demand or lead the government to enact new regulations.
Even with some tail risk looming on the horizon, we think shares look fairly valued thanks to the company's focus on lowering its cost structure. Still, we aren't interested in adding shares to the portfolio of our Best Ideas Newsletter at this time since they only score a 4 on the Valuentum Buying Index.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.