Smith & Wesson Holding Corporation (NASDAQ:SWHC) was one of Wednesday's best performing stocks, after the company reported outstanding second quarter earnings. As a result, the shares traded around 16% higher at $13.75/share. Overall, I am impressed with the company's performance in the past quarter. For example, Smith & Wesson's most important competitor Sturm, Ruger & Company (NYSE:RGR) reported worse-than-expected results last week. Despite the facts that Smith & Wesson performed much better than Sturm, Ruger & Co. and the shares soared 16% yesterday, Smith & Wesson is still undervalued compared to Sturm, Ruger & Co.
How is that possible? There are probably a couple of reasons why Sturm, Ruger & Co. trades at a higher valuation (P/E ratio) than Smith & Wesson. However, I find that the most important reason is the different opinions regarding the best way to deliver value to the shareholders. Sturm, Ruger & Co. pays a very attractive dividend (current yield: 3.40%) and has a program to repurchase shares. On the other hand, Smith & Wesson only repurchases own shares. The company does not pay any dividend to its shareholders. In this article, I will argue that Smith & Wesson should pay dividends and that the company has the resources to do so.
First, let's take a look at the trailing P/E ratio of the two companies (see graph below). Based on yesterday's close, Smith & Wesson trades at 10.70 times this fiscal year's earnings per share and Sturm, Ruger & Co. trades at 11.69 times this fiscal year's earnings per share. This equals an 8.5% difference in valuation. If I take the forward P/E ratio into account, the difference becomes even larger. Smith & Wesson trades at 9.96 times next fiscal year's earnings per share and Sturm, Ruger & Co. trades at 14.51 times fiscal next year's earnings per share (source: Yahoo! Finance).
Returning cash to shareholders
As I mentioned above, Smith & Wesson repurchased its own shares. The company repurchased the shares quite aggressively and reduced its total shares outstanding by nearly 19% in the past year (see quote below). Jeffrey D. Buchanan, Smith & Wesson's Executive Vice President and Chief Financial Officer, stated in this press release:
During the third quarter, we repurchased 1.14 million shares of our common stock for $15 million. Since December 2012, we have repurchased a total of 12.3 million shares of our common stock valued at $135 million, representing a total reduction in shares outstanding of nearly 19.0%. With the successful completion of our stock buyback program, we continued to optimize our capital structure. Overall, our balance sheet remains flexible and strong with no borrowings under our credit facility.
Generally, I favor share repurchases for the same reason as Smith & Wesson's CFO stated in the quote above. Share repurchases are very useful to optimize a company's balance sheet and control the amount of leverage. Share repurchases could provide value for its shareholders as well. However, the company needs to take on debt to finance the repurchases instead of paying out of its existing cash surplus. Let me explain.
The distribution of excessive cash on a company's balance sheet to its shareholders, through share repurchases, does not provide value for the company's shareholders. Less cash on a company's balance sheet equals a higher risk. So, investors will demand a higher risk premium for the shares. In that case, the economic value of the firm does not change at all.
In a perfect world, this applies to financing share repurchases with debt as well. However, we are not living in a perfect world. In this imperfect world, corporations have to pay taxes. In case that a company finances the share repurchases with debt, it has to pay interest. The interest is deductible from the company's net income. As a result, the corporate tax bill will be lower. This provides value for the shareholders.
Smith & Wesson financed a part of the share repurchases with debt. For example, the company issued $100 million in loan notes to replace $43 million in previous loan notes. The rest was used to repurchase shares. The company did pay a part of the repurchases in cash as well. Overall, Smith & Wesson financed 42% (57 million / $135 million) of its total share repurchases with debt and 58% with existing cash. Following the theory I mentioned above, this provided some value for the company's shareholders.
During the third quarter, Smith & Wesson's share repurchase program came to an end. It is not likely that the company will announce such a large program again. The company achieved their goal and optimized their capital structure. Now it is time to maintain the optimal capital structure. The best way to maintain the current capital structure is to declare a dividend. Further, the declaration of a dividend will support the stock in two ways. First, the shareholders appreciate the additional cash returned to them and second, the stock becomes attractive for dividend investors.
Smith & Wesson has enough resources to pay for potential dividends. Despite the large share repurchase program, the company's solvency ratio is still 40% (equity / balance sheet total). Further, Smith & Wesson currently holds $45 million in cash. It is likely that the company's cash pile will grow over time. Despite the fact that Smith & Wesson invested $77 million in the past 7 quarters, the company generated positive free cash flows (FY 2013: $18 million, 9M 2014: $6 million). Therefore, I find that the company is financially healthy and there is no major argument against the declaration of a dividend.
Smith & Wesson truly delivered a perfect shot with its third quarter earnings report. The company reported much better earnings than expected. Despite the company's strong performance, the stock is still undervalued compared to its main competitor Sturm, Ruger & Co. I find the lack of a decent dividend (one of the arguments that) could explain Smith & Wesson's lower valuation. Financially, I do not see any arguments against the declaration of a dividend. The company has enough cash, a good solvency ratio and positive free cash flows (despite the high level of investments). Therefore, the company should declare a dividend. This will attract dividend investors to buy the stock as well.
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.