Smith & Wesson: Take Profits After Repurchase-Driven Momentum

| About: Smith & (SWHC)

Investors in Smith & Wesson Holding (NASDAQ:SWHC) are applauding the company's second quarter results, accompanied by solid third quarter guidance.

After the significant momentum over the past quarter, driven by a very sizable share repurchase program, it never hurts to take some profits. That being said, I remain cautiously optimistic for the long term.

Second Quarter Results

Smith & Wesson generated second quarter revenues of $139.3 million, up 2.0% on the year before. Revenues came in slightly ahead of expectations at $137.8 million.

Income from continuing operations rose modestly to $17.1 million, up from $16.4 million last year. Diluted earnings per share rose by four cents to $0.28 per share, on the back of sizable share repurchases.

Reported GAAP earnings came in at $0.28 per share as well, down three cents compared to a year before. Last year, the company reported a $5.7 million income tax benefit. Reported earnings comfortably beat consensus estimates at $0.21 per share.

Looking Into The Results

Reported revenue growth is low, but note that adjusting for the ended distribution agreement of Walther products, revenues were up by 9.2%. Note that growth was furthermore limited due to fewer manufacturing days due to a two-week factory shut down related to the ERP system implementation.

Smith & Wesson reported solid gross margin expansion as margins rose by 610 basis points to 41.6% of total sales. The mix, manufacturing efficiencies and absence of low margin Walther sales, all boosted margins.

Operating expenses rose by 490 basis points to 20.9% of sales. Excluding costs related to the ERP system implementation, operating expenses were up by 220 basis points.

And Looking Ahead

Third quarter sales are seen between $140 and $145 million, while GAAP earnings from continuing operations are seen between $0.28 and $0.30 per share. Included in this estimate are $1.5 million of costs related to the ERP conversion. Furthermore, note that last year's third quarter included $12.7 million in sales from Walther.

Analysts were looking for third quarter revenues of $136 million, roughly unchanged from the year before, and earnings of $0.27 per share.

Full year sales are seen between $610 and $620 million, while GAAP earnings from continuing operations are seen between $1.30 and $1.35 per share. This implies that full year revenues are seen up by 4.7%, while earnings are seen up by roughly 10 cents. Consensus estimates for full year results stood at revenues of $617 million and earnings of $1.32 per share.

Valuation

Smith & Wesson ended the second quarter with $52.9 million in cash and equivalents. The company operates with $100.8 million in debt following its $100 million share repurchase program, resulting in a net debt position of around $48 million.

Trading around $12.50 per share, the market values Smith & Wesson at $785 million. This values the company at 1.3 times annual revenues and 9-10 times annual earnings, based on the full year guidance.

The company does not pay a dividend at the moment.

Some Historical Perspective

Long-term holders in Smith & Wesson have seen a lot of long-term volatility. Shares rose from levels around $1-$2 in 2004 to a peak at $20 in 2007. Shares fell all the way to lows of $2 in 2008, but ever since recovered to current levels around $12 per share, after witnessing year to date returns of 50%.

Between the fiscal 2010 and 2014, Smith & Wesson is expected to report cumulative revenue growth of 72% to $615 million. Earnings are set to more than double to some $80 million. Earnings growth on a per share basis has been more impressive, especially following the huge $100 million repurchase program, executed in recent times.

Investment Thesis

Investors in Smith & Wesson jumped up following a solid earnings report released on Tuesday after the market close. The solid results and third quarter outlook were comforting for investors.

The fact that the company did not raise the full year outlook was causing some discomfort among some analysts. On the back of the solid second and third quarter performance, this might imply that there are some risks for a slowdown in the fourth quarter.

While the operational performance is solid, and the valuation is very appealing even at today's prices, firms like Smith & Wesson are always subject to large risks. Shootings and their impacts on society, combined with political pressure, continue to impact the prospects, especially related to possible gun reforms.

The election of Obama in 2008 and the financial crisis resulted in a huge backlog for gun sales. The higher number of background checks, which are an indicator of future gun sales, continue to look healthy. As such, shareholders in gun manufacturers are always in doubt. A shooting triggers future gun sales, but also adds to political pressure to reform the gun laws with a possible devastating long-term impact.

Back in September of this year, I last took a look at Smith & Wesson's prospects. With shares trading around $10.30 per share at the time, shares have risen some 22% in just three months time. Part of this is the result of a huge repurchase program, after Smith & Wesson repurchased $100 million worth of shares. At a price of $11.09 per share, the company retired 9.0 million shares.

The growth, resulting in the new ERP system implementation, is temporarily impacting results, as the future backlog remains solid. The company is already running at full capacity for six quarters in a row, implying bright short-to-medium term prospects.

At the time, I concluded that investors should re-load and investors have seen very solid returns in a rather short time frame, following the overreaction towards the downside in September. For now, I am a bit more cautious. The strong run-up and aggressive pace of repurchases will limit short-to-medium term potential. While the long term still looks solid, it never hurts to take some profits off the table.

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.