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Smith & Wesson Holding Corp. (NASDAQ:SWHC) will report second quarter earnings on December 10, 2013. The company reported higher than expected earnings per share during the first quarter of fiscal year 2014. However, the company's share price fell in reaction to the release of first quarter earnings because investors were disappointed in the outlook for the second quarter. The company expects earnings per share between $0.20 and $0.22 during the second quarter. Despite a lower than expected outlook for the second quarter, the company raised its full year guidance and now expects total net sales during fiscal year 2014 between $610 million and $620 million (compared to $588 million during fiscal year 2013). The earnings per share for fiscal year 2014 will be between $1.30 and $1.35 per diluted share (compared to $1.18 per diluted share in fiscal year 2013).

Outlook second quarter

The first quarter earnings report, published on September 5, 2013, disclosed some explanations for the weak second quarter outlook. The company ended its Walther distribution agreement at the end of fiscal year 2013, which amounted for $9.7 million in sales during the second quarter of fiscal year 2013. No Walther sales will be recorded during the second quarter of fiscal year 2014. Further, the company reported that since the beginning of the second quarter, a new ERP system is in use. It is common that the implementation of a new ERP system requires a lot of effort from a company and the production could be down several days or weeks. It is difficult to predict the outcome of an ERP implementation. Therefore, I assume that the company was very cautions with its second quarter outlook. If the ERP implementation was a success (without major setbacks), I expect that Smith & Wesson will beat the average earnings forecast for the second quarter of fiscal year 2014 and will confirm its full year guidance.

Performance and valuation

Smith & Wesson shares trade at $11.82 a share. The shares gained nearly 40% year to date. The stock rallied in July and peaked in the first weeks of August after the company announced a $100 million tender offer at $10 a share in June. The company increased the tender price to $11 in July, but could not prevent that only 1.4 million shares (or $15.6 million) were repurchased through the tender offer. The remaining funds were used to repurchase shares in the open market. On October 1, 2013, the company announced that the $100 million share buyback program was completed and announced another $15 million share buyback program. The fact that shareholders were reserved to apply to the $11 a share tender offer and the announcement of another share buyback program imply that Smith & Wesson shares trade at a discount. That is confirmed in the graph below, which compares Smith & Wesson's and competitor Sturm, Ruger & Co's (NYSE:RGR) stock market performance year to date. Sturm, Ruger & Co. gained 70%, while Smith & Wesson "only" gained 40% this year.

(click to enlarge)

Further, I compared Smith & Wesson's and Sturm, Ruger & Co's Price/Earnings ratio. This provides an insight in the current valuation of the two stocks. According to the graph below, Smith & Wesson's P/E ratio is well below Sturm, Rugers & Co's P/E ratio (9.00 vs 14.52). There are some arguments to explain why Sturm, Ruger & Co trades at a higher P/E ratio than Smith & Wesson. First, Sturm, Ruger & Co pays a dividend (yield: 3.00%) and Smith & Wesson pays no dividend to shareholders. Second, Sturm Ruger & Co has a very strong balance sheet, with no long-term debt. Smith & Wesson has $100 million in long-term debt on its balance sheet (or 25% of the total balance sheet). So, Smith & Wesson has more leverage on its balance sheet, which increases the risk premium for the company. However, the current valuation for Smith & Wesson is very attractive in my opinion, considering that the shares of Sturm, Ruger & Co trade with a 61% higher P/E ratio compared to Smith & Wesson. The dividend payments and the strong balance sheet provide some arguments for the difference. However, these arguments should cover only a part of the 61% difference in the P/E valuation.

SWHC PE Ratio (<a href=

SWHC PE Ratio (TTM) data by YCharts

Market conditions

The demand for guns in the United States was very high during the past two years, caused by fears that the Obama administration would restrain laws regarding gun ownership. Gun control became an issue in Washington after several mass shooting incidents within the United States in 2012. These shootings raised questions whether gun ownership should be limited. Some politicians thought about even more rigorous measures, for example the ban of gun ownership. The fears regarding gun control will fade away going forward without any indications that Washington really is considering gun control. As a result, demand for guns could decrease compared to the extremely high demand in 2012 and 2013. In my opinion, this does not explain the current (low) valuation of Smith & Wesson. During fiscal year 2013, the company could not produce enough products to cover the demand for its products. A decrease in demand has not an immediate effect on the number of guns Smith & Wesson sells because of the supply constraints in the past two years. Even if the demand will decrease in the upcoming years, Smith & Wesson will sell a lot of guns and will retain the current profitability.

Conclusion

In my opinion, Smith & Wesson is an attractive investment opportunity next week in anticipation of the second quarter earnings. It is likely that the company beats the earnings forecast, if no major incidents occurred regarding the implementation of the new ERP system. I do not expect that a decrease in demand for guns will have an immediate effect on Smith & Wesson's earnings. An earnings beat could trigger an upward trend because the shares are relatively cheap considering the company's full year guidance. This is confirmed by the comparison between Smith & Wesson and Sturm, Ruger & Co. Smith & Wesson trades with a significantly lower P/E ratio compared to Sturm, Ruger & Co. Smith & Wesson's shares could rally towards the end of this year if the second quarter earnings are good and the full year outlook is confirmed.

Source: Q2 Earnings Release Will Trigger Smith & Wesson's Upside Potential