Smith & Wesson Holding Corporation (NASDAQ:SWHC) has seen its stock price come under pressure in recent months as investors and speculators placed wagers on how future regulation will impact the company. The stock is trading down almost -20% since it reported blowout earnings and guidance in early March. Meanwhile, short interest has steadily increased to almost 30% of shares outstanding. The disparity in price relative to the company's fundamentals is tremendous, and I believe provides longer-term investors with an attractive entry point. Of course, this assumes that fundamentals prevail over the long-run and that short-term price movements often reflect investors' hyper-sensitivity to headline risk.
Since 2006, Smith & Wesson has seen its revenue and earnings grow at a CAGR of 12.5% and 42.5%, respectively. By segment, handguns have grown at a CAGR of 13.5% over this period, and have averaged 50-55% of total sales. The Walther line of performance pistols has grown at a 6.8% CAGR, and represents approximately 5-10% of sales over this period. High performance tactical rifles are the fastest growing segment for the company, having grown at a CAGR of 26% since 2006, representing 20-25% of sales. (Smith & Wesson's reliance on high performance tactical rifles as a driver for future growth is why it is being favored by short-sellers relative to its peers.) Parts and accessories have experienced nice growth in-line with broader sales at a 15.5% CAGR, and represents about 5% of total firearm sales for the company.
Keeping It Simple...
Total non-firearm sales have experienced negative growth of -7.1% since 2006. This is the result of the company's fiscal-year 2012 divestiture of its perimeter security business. This was a business that former management entered into through a 2009 acquisition of Universal Safety Response, Inc. While this acquisition immediately tacked on an additional $50 million in revenue, it was at the cost of lower margins and highly reliant on government spending. When James Debney was appointed CEO in 2011, as part of a planned management succession process, one of his first acts was to divest the perimeter security business due to the above mentioned reasons. The idea was to refocus on the company's core gun manufacturing business. As a result of this and other changes, Smith & Wesson went from having three operating segments and 14 sub-segments in 2006, to two operating segments and six sub-segments in 2012. (Source: FutureNet Security Solutions)
Note: Smith & Wesson still is one of the world's largest producers of high-grade handcuffs. This figure is rolled up into the Other category in the Total Non-Firearms segment.
One of the most important determinants of a company's future value is how management allocates capital today. I believe James Debney and management have a clear, simple and successful capital allocation road map. That is, cash flow from operations is first to be used toward reinvestment and the ongoing operations of the business. Second are the debt holders, in which leftover cash is used toward making interest payments and retiring reasonable amounts of debt. Lastly, and in accordance with the capital structure, are the equity holders. Smith & Wesson has been actively rewarding equity investors through its stock repurchase program. While this may seem like a text-book capital allocation process, it is amazing how many companies fail to operate in this manner and to the detriment of all stakeholders.
Additionally, many investors have been clamoring for some type of a dividend from Smith & Wesson. I believe that will come in time. However, in the near-term, investors look at competitors such as Sturm, Ruger (NYSE:RGR) and see a market valuation twice that of Smith & Wesson when the only real difference is that Ruger has an almost 3.5% dividend yield. Given Smith & Wesson's current valuation, I much rather management buy back shares than initiate a dividend at this time. Once shares of Smith & Wesson begin to trade at valuations more in-line with the industry, that is when you will see management initiate a dividend. In the meantime, well… it usually pays to be patient.
Going forward, it is unlikely that Smith & Wesson and the entire industry will maintain the pace of growth experienced over the last five years. Much of the growth experienced during FY 2013 is the result of consumers purchasing firearms at a rapid pace in attempt to get ahead of what they perceive as impending regulation or impediments to their second amendment rights. However, rather than try to guess as to what type of gun control measures Washington will enact, I modeled three separate scenarios and assigned a probability of occurrence to each.
Base Case Thesis
My base case scenario assumes Washington passes new gun control legislation that requires universal background checks and the limiting of high capacity ammunition magazines. I believe this to be the most likely outcome and do not believe it will have a large impact on the demand for firearms. Through 2018, I anticipated Smith & Wesson total revenue to grow at a 5.0% CAGR, which is less than half of the 11.5% growth rate experienced over the last five years. I expect total handgun sales and tactical rifle sales to grow at a CAGR of 4% and 10% over the same period. This compares to a CAGR of 13.5% and 26.5% for the handgun and tactical rifle segments over last five years. Finally, I anticipate revenue growth from hunting rifles to remain flat and parts and accessories growth at 6%.
Base Case Model
Source: 10-K and Internal Projections
The premise behind my growth assumptions are that the recent increase in demand is not sustainable over the longer term and reflects consumers' fears over impending regulation. Anecdotal evidence of gun stores around the nation not being able to keep enough firearms and ammunition on the shelves to keep pace with demand supports this claim. The sell-side consensus calls for an actual decline in revenues in fiscal-2014 as a result of this demand spike. However, I believe analysts are underestimating the power of the fundamental shift in consumer psychology related to gun ownership.
Why Do You Own A Gun?
According to a Pew Research center study conducted in March 2013, the number of respondents who claimed they own a gun for "protection" jumped by 22% to 48% from only 26% when the same survey was conducted in 1999. That is a tremendous increase and unfortunately, is a sign of the times. Of course, Hollywood is partially to blame, having been fueling sentiment with a barrage of movies and television series depicting "end of the world" type scenarios (from zombies to comets). For those interested, I highly recommend reading the latest articles published by the Pew Research Center related to gun control and ownership.
Source: Pew Research Center
What Is Your Point?
My point is that this type of psychological shift among consumers has been and will continue to be a game-changer for the entire industry. This is because you only need a few different types of rifles and handguns if you are a hunter or target/sport shooter, but you can never have enough guns and ammunition for protection purposes. Therefore, while I do anticipate revenue growth to slow to 5%, I do not expect a year-over-year decline.
With the restructuring behind them, investors have been provided a clearer picture of the cost structure of the company. Margins and earnings have been relatively stable and easy to predict. Therefore, with a recent price increase already behind it and no big acquisition or expansion plans, I expect gross margins to remain flat around 37% through 2018. Similarly, operating expenses are expected to stabilize around 15.5% over the same period.
Base Case Valuation
In my usual fashion, I used several valuation techniques to arrive at an estimate of fair value for Smith & Wesson. The idea is that taking a combined and weighted approach offsets the biases and shortcomings of each stand alone method. Rather than painstakingly describe each figure, I provided my valuation summary below. The multiples displayed were chosen as conservative midpoints on a historical basis and relative to peers.
Bull Case Scenario
My bull-case scenario has revenue growing at approximately 7.5% through 2018. This assumes that Washington passes the same type of legislation as in my base case. Handgun and tactical rifle revenue grows at 6.0% and 14.0%, respectively, over the same period. Meanwhile, revenue from the Walther line of performance pistols and parts and accessories grows at 2.5% and 7.0%, respectively. I anticipate that gross margins will improve approximately 50 bps or 0.50% per year due to a combination of price increases and manufacturing efficiencies as the result of increased demand. This translates into earnings growth of approximately 10% over the next five years.
Bull Case Model
Source: 10-K and Internal Projections
Bull Case Valuation
The bull case valuation uses the same discount rate as the base case valuation, but assumes a higher multiple on earnings, EBITDA and sales. The multiples were derived from a peer group analysis, including the likes of Sturm, Ruger and Company.
Bear Case Scenario
My bear-case scenario incorporates the impact of a complete assault weapon ban beginning in the second-half of 2014, thus resulting in the elimination of $130 million in revenue per year. Handgun demand will benefit slightly as a substitute, but will still only grow at a 1.5% CAGR over the next five years. Meanwhile, gross margins will suffer, declining to 25% before rebounding slightly as the company copes with the loss of the tactical rifle division. This results in an overall five-year forward revenue CAGR of -1.2% and -2.0% earnings CAGR.
SWHC Bear Case Model
Source: 10-K and Internal Projections
Bear Case Valuation
The bear case valuation assumes the same discount rate, but significant multiple compression as result of the negative growth and regulatory shock.
At a current price of $8.50/share, shares of Smith & Wesson seem attractively priced for investors willing to look past the near-term, headline risk. The stock is trading at 40% above the bear case price target of $5.03, which assumes a complete assault weapon ban and a negative five-year growth rate. You may have noticed that the regulatory risk premium is 0%. Rest assured, this is by design. It is a plug and play, and it shows that in order to arrive at the current price of $8.50/share, the regulatory risk premium would have to be 7.5%. Overall, the probability of this scenario materializing is low, and therefore, I assigned a 10% probability weighting to this price target (probably too conservative).
I believe the base case scenario has the greatest probability of occurrence (60% probability) and most accurately reflects consumer demand and the regulatory backdrop over the next five years. The base case scenario represents approximately 83% upside from current levels. Meanwhile, the bull case scenario (30% probability) assumes stronger than expected consumer demand and a price target of approximately $22/share, or 160% upside potential. This is attractive risk/return.