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Last week I wrote this article regarding Smith & Wesson Holding Corporation's (NASDAQ:SWHC). I concluded that the stock was an attractive investment opportunity in anticipation of the second quarter earnings, because an earnings beat should trigger Smith & Wesson's upside potential. Smith & Wesson's shares closed at $12.12 after today's trading session. The shares are up 2.5% since I published my previous article (see graph below).


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In my article, I concluded that Smith & Wesson would beat the earnings forecasts, because of the company's ERP implementation during the second quarter. Companies intend to be cautious regarding the effects of an ERP implementation, while the outcome is somewhat uncertain. In my article stated:

It is likely that the company beats the earnings forecast, if no major incidents occurred regarding the implementation of the new ERP system.

Q2 earnings report

Today, Smith & Wesson released their second quarter earnings report. The company reported better than expected sales and earnings over the second quarter en confirmed their full year guidance. No major incidents occurred with the ERP implementation. Several highlights from the earnings report are described below:

Net sales for the second quarter were $139.3 million, up 2.0% from the second quarter last year. Handgun sales, which included sales of the company's popular M&P pistols, grew 27.4%.

Gross profit for the second quarter was $57.9 million, or 41.6% of net sales, compared with gross profit of $48.5 million, or 35.5% of net sales, for the comparable quarter last year.

Operating expenses for the second quarter were $29.2 million, or 20.9% of net sales, compared with operating expenses of $21.8 million, or 16.0% of net sales, for the second quarter last year.

Excluding one-time go-live costs related to the company's new ERP system, operating expenses would have been $25.3 million, or 18.2% of net sales.

Income from continuing operations for the second quarter was $17.1 million, or $0.28 per diluted share, compared with $16.4 million, or $0.24 per diluted share, for the second quarter last year.

Valuation

Smith & Wesson's second quarter earnings per share beat consensus by $0.06, or 27 percent. Further, the company's outlook for the third quarter is better than expected. My initial assumptions were right. No major incidents occurred regarding the ERP implementation and Smith & Wesson managed to deliver great results over the second quarter. As a result, the shares are up over 6 percent in the aftermarket, and currently trade around $12.90 a share.

So, the second quarter earnings did trigger Smith & Wesson's upside potential. However, the current rise of the shares is just the beginning. Even with today's aftermarket gain, the stock is valued at 9.9 times the estimated earnings per share for this year. This is still considerably lower compared to Smith & Wesson's main competitor: Sturm, Ruger & Co (NYSE:RGR).

Sturm, Ruger & Co is valued at 14 times the estimated earnings per share for this year, or 41% higher compared to Smith & Wesson. I considered several arguments why Sturm, Ruger & Co. should be valued at a bit higher EPS multiplier:

  1. Strong balance sheet: Sturm, Ruger & Co. has no long-term debt on its balance sheet and a 61% solvency ratio, where
    Smith & Wesson has $100 million in long-term debt on its balance sheet and a 38% solvency ratio.
  2. Dividend: Sturm, Ruger & Co pays a stable dividend. The current yield is 3.00%. Given the fact that the company has no long-term debt, the dividend is paid out of free cash flow. Smith & Wesson pays investors no dividend.

However, these arguments do not fully cover Smith & Wesson's 41% lower valuation compared to Sturm, Ruger & Co, as I stated in my previous article. Even with the 6 percent rise of the share price during the aftermarket trading session, there is plenty of upside potential left for Smith & Wesson's shares to rise.

Short interest

The current short interest could be a catalyst for Smith & Wesson's upside potential. The current short interest is 18.5 million shares, nearly 33% of the total number of shares outstanding. It takes 14.4 days with an average volume to cover the short interest (see graph and table below).


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Since the second quarter earnings report boosted the share price by 6 percent, several investors and traders need to close their short positions in Smith & Wesson, especially when the current share price gain retains during tomorrow's trading session. This will support the increase of the share price even further, which could trigger other short sellers to close their positions as well.

Conclusion

Smith & Wesson delivered great second quarter earnings and beat the analysts' consensus. Further, no major incidents occurred with the ERP implementation. I confirm my initial conclusion and remain bullish on Smith & Wesson, because the company is still undervalued compared to its main competitor Sturm, Ruger & Co. The closure of some short positions could support the share price even further. I consider $15.00 per share a realistic share target by the end of this month.

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.

Source: Smith & Wesson's Upside Potential Confirmed By Earnings Beat