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Description of Company

Smith & Wesson Holding Corporation (NASDAQ:SWHC) is one of the world's leading manufacturers of firearms. The company is known for producing handguns, long guns, black powder firearms, handcuffs, and firearm-related accessories to individuals, law enforcement agencies, security agencies, and military agencies in the United States and throughout the world.

Smith & Wesson has a multi-prong growth strategy including, but not limited to, the introduction of new products, enhancing current products, enhancing manufacturing productivity, and pursuing strategic relationships and acquisitions.

Smith & Wesson has introduced many new handgun and long-gun models in the past two years, such as the M&P Shield, SDVE, Model 41, M&P 10, and M&P 15 Sport. Smith & Wesson plans to introduce more new firearm products for fiscal year 2014.

Smith & Wesson has a strategic relationship with Carl Walther GmbH until the end of fiscal year 2015, wherein Smith & Wesson has a production rights agreement to produce the Walther PPK and PPK/S pistols for Walther until the end of fiscal year 2014, and Walther will manufacture the Smith & Wesson M&P22 pistols until the end of fiscal year 2015.

The Case for Investment

Smith & Wesson fits almost all of the criteria that I look for in a growth stock. First, it has a P/E ratio of 9.80 and a forward P/E ratio of 9.01, although the forward P/E ratio is a slight decline from the current P/E ratio, it is still in the range that I like to see. Second, Smith & Wesson with a PEG ratio of 0.3 is very low compared to other available securities in the same industry, which leads me to believe that the stock is undervalued relative to its growth. Third, Smith & Wesson has had a sales growth rate for the past five years of 14.7%. Fourth, double-digit sales growth is a good sign that the company is doing something right. Finally, the EPS growth rate for Smith & Wesson for the past five years has averaged 40.9%, which is quite impressive, and the five-year forward-looking EPS growth rate is expected to be 30.0%. I believe that a closer look at Smith & Wesson is warranted. Let's see how it performs compared to the industry.

Industry Position vs. Competition

Smith & Wesson has outperformed other aerospace & defense industry with regard to quarterly year-over-year sales growth, quarterly year-over-year net income growth, five-year average sales growth, and five-year annual net income growth.

SWHC Growth Rates Compared to Industry

Growth Rates

SWHC

Industry

Sales (Q v. Year Ago Q)

25.8%

5.24%

Net Income (Q v. Year Ago Q)

40.6%

11.53%

Sales (5Y Annual Average)

14.7%

9.75%

Net Income (5Y Annual Average)

54.9%

4.18%

Ok, sales and income are good, but how about profitability? Looking at Smith & Wesson's performance compared to the industry, the company outperforms on gross margins, pre-tax margins, and net margins.

SWHC Profit Margins Compared to Industry

Profit Margins

SWHC

Industry

Gross Margin

39.89%

15.51%

Pre-Tax Margin

22.52%

7.81%

Net Margin

13.31%

5.2%

So far, we see that Smith & Wesson is outperforming on sales, net income, profitability. Now, let's look at the financial ratios to see if the company is taking on too much debt compared to other companies in the industry. Smith & Wesson has a lower debt-to-equity ratio and leverage ratio compared to the industry, which tells me that Smith & Wesson is not taking on a high amount of debt compared to other companies in the industry. Smith & Wesson has a current ratio and quick ratio that is much higher than that of the industry. Smith & Wesson should not have any problems meeting short-term debt obligations. One figure not shown in the table is Smith & Wesson's price-to-free cash flow "P/FCF" ratio. Currently, it is 13.23, and Smith & Wesson has the second lowest P/FCF ratio in the defense and aerospace industry, which indicates that Smith & Wesson is a good value relative to its current stock price.

SWHC Financial Condition Compared to Industry

Financial Conditions

SWHC

Industry

Debt to Equity Ratio

0.76

0.84

Current Ratio

2.44

1.32

Quick Ratio

1.41

0.54

Interest Coverage Ratio

13.61

14.36

Leverage Ratio

2.61

6.92

Book Value per Share

2.34

18.13

Smith & Wesson had some performance hiccups in the past, but has managed to turn around investment performance for the better. This change in investment performance currently is a vast improvement over its historical five-year average for return on equity, return on assets, and return on capital.

SWHC Investment Performance Compared to Industry

Investment Returns

SWHC

Industry

Return on Equity

57.42%

37.69%

Return on Assets

26.37%

4.94%

Return on Capital

34.91%

18.59%

Return on Equity (5Y Average)

-13%

37.21%

Return on Assets (5Y Average)

-1.5%

5.52%

Return on Capital (5Y Average)

-4.4%

17.98%

With regard to how management is performing, Smith & Wesson generates much higher income per employee and revenue per employee. These figures indicate that management is efficient in utilizing its employees to generate revenues for the company. Smith & Wesson has a receivable turnover ratio in line with industry performance, but its inventory turnover and asset turnover ratios are well above the industry average. These ratios tell me that management, overall, is doing a good job.

SWHC Management Ratio Compared to Industry

Management Efficiency

SWHC

Industry

Income per Employee

56,410.17

19,364.17

Revenue per Employee

423,913.90

349,980.21

Receivable Turnover

10.17

10

Inventory Turnover

5.31

2.64

Asset Turnover

1.98

0.95

Assessment of Risks

Highly Dependent on One Distribution Channel

Approximately 89.0% of Smith & Wesson's net firearm sales remain in the sporting goods distribution channel. Smith & Wesson is making efforts to mitigate this dependency by increasing sales to law enforcement and military agencies.

Capacity Constraints Can Hinder Market Share

Although product operational throughout increased from 2012 to 2013, Smith & Wesson experienced capacity constraints. In the future, continued capacity constraints could prevent customer orders from being fulfilled resulting in market share lost to competitors.

Acquisition Strategy Has Resulted in Substantial Write-Offs

Smith & Wesson has a multi-prong growth strategy, one of which is acquisitions; however, the only two acquisitions completed to date, Thompson/Center Arms in 2007 and SWSS in 2009, resulted in substantial write-offs. Future acquisitions undertaken by Smith & Wesson should be more carefully scrutinized to prevent the same results.

EPS Growth Expected to Decelerate

EPS growth for Smith & Wesson for the last five years averaged 40.9%; however, looking forward to the next five years the EPS growth will decelerate to a 30% EPS growth rate. Usually, I like to see companies show increased EPS growth rates moving forward when comparing to the past, but in this case, with this company, I am not too worried.

Valuation and Pricing Target

Smith & Wesson Holding Corporation is estimated to report earnings on March 4, 2014. I am not expecting to hear any adverse earnings news. If there is an earnings surprise, historically, there has been a surprise to the upside.

SWHC Earnings Surprise History

Description

(10/12)

(1/13)

(4/13)

(7/13)

(10/13)

Estimate

0.23

0.21

0.43

0.36

0.21

Actual

0.24

0.26

0.44

0.40

0.28

Difference

0.01

0.05

0.01

0.04

0.07

% Change

+4.35%

+23.81%

+2.33%

+11.11%

+33.33%

Currently, the analysts have a mean price target of $16.15. I will provide two of my own price targets. The first price target is where I expect Smith & Wesson to reach before the end of the year. The second price target is a long-term five-year price target. The end-of-year price that I forecast for Smith & Wesson is $17.59, which is slightly above the mean analyst price target. This is simply based on a standard deviation move of an at-the-money option expiration on or after the end of 2014. For those that are considering Smith & Wesson as a long-term value play, I am forecasting a five-year price target of $44.16. For longer-term pricing targets I consider the five-year discounted cash flow based on earnings and earnings growth rates with a discount rate of 10%. At this price, I believe the future cash flows of Smith & Wesson will be fully priced into the stock.

Source: Smith & Wesson: Sight Alignment Points Toward Growth