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Smith & Wesson Holding Corporation (NASDAQ:SWHC)

F4Q 2014 Earnings Conference Call

June 19, 2014 17:00 ET

Executives

Liz Sharp - Vice President, Investor Relations

James Debney - President and Chief Executive Officer

Jeff Buchanan - Chief Financial Officer

Analysts

Andrea James - Dougherty & Company

Cai Von Rumohr - Cowen & Company

Scott Stember - Sidoti

Reed Anderson - Northland Securities

Brian Ruttenbur - CRT Capital

Scott Hamann - KeyBanc Capital Markets

Operator

Good day, ladies and gentlemen and welcome to the Q4 2014 Smith & Wesson HLDG Corp Earnings Conference Call. My name is Whitley and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this call is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Ms. Liz Sharp, VP of Investor Relations. Please proceed.

Liz Sharp - Vice President, Investor Relations

Thank you and good afternoon. Our comments today may contain predictions, estimates and other forward-looking statements. Our use of words like anticipate, project, estimate, expect, intend, believe and other similar expressions is intended to identify those forward-looking statements. Forward-looking statements also include statements regarding revenue, earnings per share, fully diluted share count and tax rate for future periods, our product development focused initiatives, objectives and strategies; market demand for our products, growth opportunities and trends; the expected benefits of our May 2014 asset purchase and the progress and expected benefits of our Houlton, Maine facility conversion.

Our forward-looking statements represent our current judgment about the future and they are subject to various risks and uncertainties. Risk factors and other considerations that could cause our actual results to be materially different are described in our securities filings, including our Forms 8-K, 10-K and 10-Q. You can find those documents, as well as a replay of this call on our website at smith-wesson.com. Today’s call contains time-sensitive information that is accurate only as of this time and we assume no obligation to update any forward-looking statements contained herein. Our actual results could differ materially from our statements today.

I have a few important items to note with regard to our comments on today’s call. First, we reference non-GAAP adjusted EBITDAS on this call. Note that the reconciliation of GAAP income from operations to adjusted EBITDAS can be found in today’s filing, as well as today’s earnings press release, which are both posted to our website. Also, when we reference EPS, we are always referencing diluted EPS. And finally, please note that this call references only our continuing operations. For the results of our discontinued operations, please refer to our 10-K for the period ended April 30, 2014, which filed this afternoon.

I will now turn the call over to James Debney, President and CEO.

James Debney - President and Chief Executive Officer

Thank you, Liz. Good afternoon, everyone and thanks for joining us. With me on today’s call is Jeff Buchanan, our Chief Financial Officer. Later in the call, Jeff will provide a recap of our financial performance as well as our guidance outlook.

Before we begin, I want to extend my thanks to all of our employees at Smith & Wesson for their commitment and the contribution that resulted in a year of record performance. Fiscal 2014 was a dynamic and rewarding year for Smith & Wesson. Our results include the higher sales, gross margin and profit in the company’s history. They also include the successful implementation of our new ERP system, an important part of our overall strategic plan.

Our successful performance was driven by robust consumer demand for our products, combined with carefully managed increases in our manufacturing capacity and flexibility. Our achievement is aligned directly with our great strategy, which is underpinned by a highly disciplined focus on our core firearm business. That focus helps us to deliver double-digit sales growth, expanded gross margins and considerable improvement in earnings per share. Equally important, we believe we made substantial gains and increasing our share in the U.S. consumer market for handguns and modern sporting rifles. By maintaining our focus and continuing to execute on our strategy, we believe that we are well-positioned to take share and deliver profitability at the consumer market returns to a normalized environment.

Now, let me provide a few highlights from the fourth quarter. We delivered growth in unit sales of our handguns of more than 30%. This strength in our handgun business which is core to our long-term growth strategy was offset by weakness in long guns as consumer demand in the modern sporting rifles cooled significantly. As a result of that cooling which was not a surprise, total sales for the fourth quarter came in slightly lower than the prior year.

Overall, we are pleased with this result which came in above our guidance, especially when we consider the weakened market demand for modern sporting rifles. We continue to see channel inventories remain low for several of our products through the fourth quarter. Since April 30, however, channel inventories for most of these products have now reached optimal levels and I will elaborate on that later in my remarks.

We commenced shipping our M&P Shield and SDVE pistols to California, two key products that are highly desired by the consumer. We vertically integrated a critical manufacturing process by forming a new company called Deep River Plastics and acquiring the assets of our principal plastic injection molding supplier. I believe this was a smart strategic move when we consider how much of our revenue is generated by products that contain polymer components.

We remained on track to complete the conversion of our Houlton operation to a precision machining center, an initiative that reflects our focus on profitability. Lastly, we continued to return value to our stockholders through our common stock repurchases, which significantly reduced our share count.

With that, I will ask Jeff to review the financial results.

Jeff Buchanan - Chief Financial Officer

Thanks, James. Revenue for the quarter was $170.4 million, which was down 4.6% from the prior year. Excluding Walther, revenue in the quarter decreased 1.5%, although total handgun revenue grew by 24.2% nearly offsetting the decline in long guns. Sequentially, revenue rose 16.8% as Q4 is typically our seasonal highpoint. Revenue for the full year was $626.6 million, which was up 13.8% over the prior year, excluding Walther.

The gross margins were 40.9% for the fourth quarter and 41.3% for the full fiscal year. The gross margin improvements in fiscal ‘14 primarily resulted from improved fixed cost absorption as a result of high capacity utilization. Also helping were a favorable product mix and reduced promotions, both of which were enabled by the surge and the end of the Walther agreement.

In the quarter, operating expenses were $26.7 million or 15.6% of revenue. And for the year, operating expenses were $108.1 million or 17.3% of revenue. Operating expenses in fiscal ‘14 rose as a result of higher sales and marketing expenses, our SAP implementation and employee-related costs. Operating margin was 23.5% in the fourth quarter compared to 26.2% in the comparable quarter last year. For the full year, operating margin was 24.1% compared to 22.6% for the prior year.

Net income in Q4 was $24.9 million for a fully diluted EPS of $0.44, which is – which matches EPS from the year ago quarter. Fully diluted EPS for the entire year was $1.47 as compared with $1.22 for the prior year. I would point out that in the fourth quarter, the Department of Justice notified us that it declined to pursue any charges against us regarding the legacy FCPA matter from 2010 and it has closed its investigation. In addition, we are close to resolution of that same legacy issue with the SEC. As a result, other income in the fourth quarter includes approximately $2 million of estimated expense related to a pending final resolution of that matter. Without this accrual, EPS in the fourth quarter would have been $0.48 and EPS for the year would have been $1.51.

Non-GAAP adjusted EBITDAS in Q4 was $50 million as compared with $52.7 million a year ago period. Non-GAAP adjusted EBITDAS for fiscal 2014 was $179.5 million as compared with $154.2 million in the prior year, a 16.4% increase. For the year, operating cash flow was $90.2 million and capital spending was $53.3 million. Fiscal ‘14 was a peak year for capital spending as we implemented a new SAP system and focused on increasing our manufacturing flexibility and capacity. Although we believe that our maintenance CapEx is approximately $25 million, which now includes our Deep River Plastics facility, we estimate that total capital spending in fiscal ‘15 will approximate $40 million as we continue to add modules to our SAP system and tool up for new product introductions.

So, turning to the balance sheet, we ended the year with $68.9 million in cash, no borrowings on our line of credit, and $100 million of outstanding senior notes. I would point out that during the first quarter, we will record a cash payment of approximately $24 million for our Deep River Plastics acquisition. During the fourth quarter, our Board of Directors continued to focus on returning value to our shareholders by authorizing the repurchase of an additional $30 million of the company’s common stock, a program that commenced on the first day of our fiscal ‘15. Under that authorization, we have repurchased approximately 200,000 shares of stock at an average share price of just under $15. We will continue to aggressively buyback shares under this new authorization once our trading window was opened after this earnings release.

As a reminder from December 2012 through April 2014, which was the end of our fourth quarter, we repurchased 12.3 million shares of our common stock at an average share price of approximately $11 for a total stock buyback of $135 million and a reduction in float of nearly 19%.

And with that, I will turn the call back over to James for a discussion of our operational results.

James Debney - President and Chief Executive Officer

Thank you, Jeff. To reiterate our strategy at Smith & Wesson, we do not simply react to the market, but rather manage our business for the long-term. In a way, that gives us the ability to take market share independent or whether or not the market is growing or shrinking. That strategy drives the way we manage our company from new product development to operations management to budget planning. It has served us well throughout the surge as demonstrated by our financial and operational results. And it is designed to continue serving us well as the market returns to a more normal environment.

Total unit sales into the domestic consumer channel in the fourth quarter increased over 9%, excluding Walther. This compares favorably to adjusted mix for the same period, which decreased by 20%. As we all know, last year’s mix numbers were exceptionally high. So, overall negative year-over-year comps were to be expected. Over the long-term, however, we believe the market should continue to expand. Within mix, handgun-related checks decreased 11% compared to our unit handgun growth of over 30% for the same period. We view this as extremely favorable since taking market share with handguns is core to our long-term growth strategy. And we believe we took share even when you take into account inventory replenishment that occurred in the channel.

Turning now to channel inventories, as a reminder, we analyze six weeks of lagging distributor sales and inventory data in order to calculate our weeks of cover in the channel. We have a maximum threshold that we do not like to exceed. And ideally, we prefer to have no more than eight weeks of cover in the channel. Our analysis at the end of the fourth quarter indicated that overall, we were below that eight-week threshold. However, more recent reports indicate that channel inventories have further replenished. Since the end of quarter four, we believe that the level has moved to over eight weeks largely due to modern sporting rifles. We will continue working closely with our distributors and retailers to help make sure their orders accurately reflect their needs. We believe that channel inventory of modern sporting rifles, and here I am talking about all brands will work its way through the channel by the end of the calendar year.

Regarding our internal inventories, sequentially our fourth quarter inventory was about flat to the third quarter. We would actually be comfortable with slightly higher level of inventory, because a portion of our sales are direct to big box and independent retailers. We need to maintain finished goods inventory in order to remain operationally efficient and to provide the best possible service to those retail customers.

Turning now to new products, two strong drivers of market growth remain new shooters and broader general need for personal protection. We keep this in mind as we continue to populate our new product pipeline. Our development process for new products remains focused on extending and strengthening our successful M&P and Smith & Wesson brands. Just two weeks ago, we launched our new M&P Shield with no thumb safety in response to law enforcement and consumer feedback. And we have two meaningful new product announcements coming up within the next 60 days.

Turning to operations, the formation of Deep River Plastics was completed in May 2014. This transaction strengthens our firearm business with increased flexibility, lower production costs and reduced risk in our supply chain. And it also enhances our new product development process. The conversion of our Houlton, Maine facility to a state-of-the-art precision machining center represents an opportunity to improve efficiencies and reduce our manufacturing costs while also lowering overall operational risk. In addition by optimizing our manufacturing footprint, we have also generated space in our facility in Springfield for future growth. The Houlton conversion remains on track for completion this fall.

In conclusion, we continue to believe that our industry is in the midst of a long-term and sustainable growth trend. And our objective is to grow faster than the market by taking share. Our positive results are based not only on the strong consumer market for our firearms, but also on our ability to design and deliver products that consumers’ desire. In addition, our flexible manufacturing operations remain responsive to an ever changing environment. Going forward, we remain focused on investing in marketing initiatives that communicate directly with the consumer and raise product and brand awareness bringing to market innovative new products that meet the needs, wants and desires of a growing and diverse base of responsible firearm users, seeking vertical integration opportunities to improve gross margins and reduce risk in our supply chain and improving the processes we use to operate our business and distribute our products in the marketplace.

And with that, I will ask Jeff to provide our financial outlook.

Jeff Buchanan - Chief Financial Officer

Thanks, James. Based on overall lower demand for long guns and the summer seasonal slowdown, we estimate that our first quarter revenue will be between $130 million and $135 million. I will also point out that approximately one week of our annual two-week shutdown will fall into Q1 reducing our manufacturing by three days as compared to last year and impacting production by approximately $6 million to $8 million. We anticipate first quarter EPS of between $0.23 and $0.25. For the full year, we are estimating 2015 revenue of between $585 million and $600 million and EPS of between $1.30 and $1.40. This forecast takes into account reduced long gun demand, our recent handgun market share gains, our planned new product introductions, and our expectations regarding the long-term growth of the overall firearm market. These estimates are based on our current fully diluted share count of 56.3 million shares. We expect our tax rate to be stable at 36%. James?

James Debney - President and Chief Executive Officer

Thanks, Jeff. Operator, please open up the call for questions from our analysts.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Andrea James with Dougherty & Company. Please proceed.

Andrea James - Dougherty & Company

Hi, guys. Thanks for taking my questions.

James Debney

Hi. How you are doing?

Andrea James - Dougherty & Company

Good, thank you. And so you guys had kind of historically talked about the business at least over the last year as maybe being an 8% to 10% grower long-term. Now, it looks like you are guiding to maybe a 5% retraction in this upcoming year. And so I am just curious if you are kind of changing how you are talking about the business long-term and then maybe what’s the caused the change in sentiment for the next year?

James Debney

No, not at all. We are not changing our long-term view whatsoever. We still see that on average over the longer term that the market we should expand about 8% to 10% per annum. So, again, remember that’s an average per year over a longer term.

Andrea James - Dougherty & Company

Okay. And then the factory shutdown this year, can you just give the number of days, what’s the difference between you said it was three days more shutdown this year than last year, what’s the reason for the difference versus a year ago?

Jeff Buchanan

It’s mainly because like last year we are on a 52-week, 53-week like year end and we switch this year. So, the quarter started at a different time. Also the shutdown kind of the straddling two quarters and sometimes like depending on when a quarter ends, it ends at a different time. So, last year, we had 63 days of production. And this year, we have 60 days.

Andrea James - Dougherty & Company

Thank you very much. I will hop back in the queue.

James Debney

Andrea, can I just talk about your first question?

Andrea James - Dougherty & Company

Yes, please.

James Debney

And I just looked at some data, so if you look at the last 7 years, our adjusted mix is up on average every year, 9.4%, okay. Post the surge that first started in ‘08, so the one before the one we have just been through obviously, you saw a drop in mix of just over 1% when you look at calendar year ‘09 to ‘10. So, in terms of how that impacted Smith & Wesson’s revenues, we dropped by around about 4.5% year-on-year for our fiscal year. And what you are actually seeing this year is exactly the same thing. Coincidentally, I must say, because we do an awful lot of modeling, we do a very rigorous – go through a very rigorous process, but coincidentally, the revenue you are seeing from this year’s result dropping to the midpoint of our guidance is pretty much exactly the same in percentage terms.

Andrea James - Dougherty & Company

Got it. And so you think you will fall about half the rate of the mix, because you are taking share within the overall market, is that about the right way?

James Debney

Yes, because really we are taking – we are taking share in handguns as we know. MSRs are the ones that have been hit harder. So, that’s why we know as we are looking at long guns, we see that’s taking the hardest hit post surge, in particular in the first quarter, because we are in the slow summer period now. Historically, if you look at the last six years of mix, our Q1 falls in the three slowest months of the year for adjusted mix checks.

Andrea James - Dougherty & Company

And does your guidance factor in, this will be my last thing and does your guidance factor in any potential bump that could be related to the upcoming election or would that provide a little bit of upside sort of an out of the norm election year bump?

James Debney

Yes, that’s extremely difficult to model. So, we have not taken anything into account there.

Andrea James - Dougherty & Company

Thank you.

James Debney

Thank you.

Operator

Our next question comes from the line of Cai Von Rumohr with Cowen & Company. Please proceed.

Cai Von Rumohr - Cowen & Company

Thank you very much gentlemen. Good performance again. So, maybe you could give us the number of manufacturing days by the last three quarters just so we can kind of get it and get that into our model correctly?

Jeff Buchanan

So, let me see, let me get that. Manufacturing days, boy, you know, I had that and now it’s – hang on a second, I have it right here. Actually, I don’t. Cai, I will circle back and I will give that.

Cai Von Rumohr - Cowen & Company

Okay, that’s great. So, another question would be could you give us a little color on your assumptions this year, you have given us kind of the revenues, but maybe give us the assumptions what does that assume about gross margins and you have such a high level of op expenses, where are they expected to be including SAP and perhaps the tax rate? Thank you.

Jeff Buchanan

Okay. I mean our operating expenses we expect to kind of stay in this range, obviously with the acquisition of Deep River Plastics that adds about $0.5 million a quarter of OpEx. The OpEx obviously is up a little bit as compared to the surge period, because it is over sales expenses and promotions in this period. So, I think the range that we are in is the range that it’s going to be. The tax rate should be like 36% roughly every year.

Cai Von Rumohr - Cowen & Company

Okay. And then your SAP expenses, where were they last year and where would you expect they might be this year?

Jeff Buchanan

Yes. We spent about – we expended including capital otherwise about a little over $30 million on SAP. And about half of that was actual expense. We are going to like continue on that…

Cai Von Rumohr - Cowen & Company

Is $15 million in the op expense was SAP expense?

Jeff Buchanan

That’s correct.

Cai Von Rumohr - Cowen & Company

So it was huge?

Jeff Buchanan

Yes, it’s big, it’s big. So, it’s a big effort. We are going to continue spending that in this year, but it should that expense should tail off as we end this like fiscal year.

James Debney

Maybe you have to remember Cai, some areas of the business historically has under-spent in. We had a very old legacy system. How many years was it, Jeff?

Jeff Buchanan

17.

James Debney

17-year legacy system. So, we are well past due for an ELP conversion. And as I said this has been in under-resourced, under-spent area for sometime.

Cai Von Rumohr - Cowen & Company

But where was it in the fourth quarter, maybe I have it incorrectly, but I have like it was about $5 million, it was about $6.5 million in the first three quarters, maybe I have that incorrect?

Jeff Buchanan

Well, I mean, actually a lot of that SAP expense was back-loaded in the year, because of the fact that until we went live, it was capitalized. And after that, it was expensed. So, lot of the expense last year was sort of back loaded. And Cai, just real quick, so the days of high production – I will give you the days of high production last year in fiscal ‘14 and in this year fiscal ‘15.

Cai Von Rumohr - Cowen & Company

Yes.

Jeff Buchanan

Okay. So, in fiscal ‘14, it was 63, 58, 57, and 63, that’s quarter one through a quarter four. In this year, it’s going to be 60, 59, 56, and 64.

Cai Von Rumohr - Cowen & Company

Okay. But as I recall, you only effectively had 50 in the second quarter because….

Jeff Buchanan

Yes, it’s exactly right. SAP actually like knocked that down. 57 was the actual available days. We actually ended up only able to do about 50 because of SAP.

Cai Von Rumohr - Cowen & Company

Okay. And the last one, so if you did basically $15 million of SAP expense, would it be big number in the final quarter? Is it going to be $15 million this year or sort of starting out little lower than that trailing off as we go through the year high in the early part? Can you give us some color on that? Thanks.

Jeff Buchanan

Yes. I think it’s going to be fairly even over the year. We have a bunch of projects that we are working on that are not capitalizable. Like some of the new projects that we started, the new modules that we start will start towards the end of the year, just like for example, when we put SAP down in Deep River, that as you work on that, that will become uncapitalizable until you turn it on. So, this year the SAP expense that we have is kind of pro rata like throughout the year.

Cai Von Rumohr - Cowen & Company

Okay, that is great. Thank you very much gentlemen.

James Debney

Thanks Cai.

Operator

Your next question comes from the line of Scott Stember with Sidoti. Please proceed.

Scott Stember - Sidoti

Good evening.

James Debney

Hi, Scott.

Scott Stember - Sidoti

Hi. Could you just go over again, I am not sure, I got all the numbers down for the total increase in sales in the consumer channel for you guys and what was handgun again, if you exclude Walther?

Jeff Buchanan

So, you are asking the total of sales of handguns in Q4 was $124.1 million excluding Walther, 72.8% of sales.

Scott Stember - Sidoti

Okay. Yes, the retail sales in the consumer channel, I think you had said it was up 9%, handguns were up 30%, I just wanted to make sure I got those numbers correct?

Jeff Buchanan

Yes. Handguns were up 30%.

Scott Stember - Sidoti

And the total was up 9%.

Jeff Buchanan

That’s correct, because long guns were seriously down.

Scott Stember - Sidoti

Okay. And if we just go back to the inventory, it sounds as if after the quarter ended that I think you said that we are seeing inventories slightly above where you want to see that eight-week threshold? And you said that handguns, I mean, sorry, MSRs and long guns were above. Could you just quantify how far above and then may be just give us an idea of how far below handguns were? So, we could just better delineate what’s going on between the two businesses or the two segments?

James Debney

We really don’t give anymore details than that. We have obviously started recently just to give a bit of color on where inventory sits in the channel with our two-step distribution promise, but what I will say is we are not overly concerned about where we are. It’s really typical for this time of year, because again we are in that summer slowdown that I referenced earlier, the three months that makeup our first quarter, our Q1 are the three slowest months for adjusted mix in the whole year. So, you would expect weeks cover to increase as velocity does slow in terms of sales. And as I said that is largely driven by MSRs. And again, that’s no surprise as well. You really do have a lot of inventory of other brands when it comes to MSRs in the channel choking the channel up a little bit. Plus for us another thing again that sort of alleviates my concern is we are rapidly approaching our two-week shutdown. So, we won’t be making any customer shipments during that period. So, as you can imagine, that will help to bring inventory down. If we did decide to make shipments during a shutdown which we have done from time-to-time, it’s a very minimal impact.

But once we get into August, get August past and then into September, history tells us that, that’s when mix checks begin to accelerate again as consumer start shopping more strongly for firearms than they did during our quarter one. So, another thing we need to be conscious of and careful about is we need to make sure we have adequate inventory of the correct mix internally as I said earlier, because we are direct to retail in some instance, but in the channel with our two-step distribution partners that we can optimize product placement in retail.

Scott Stember - Sidoti

Okay, got it. Okay. And so just basically it doesn’t sound as anecdotally as far as handguns go, there really does not seem to be any issues there, this is mostly if not all driven by MSRs, correct?

James Debney

Largely driven by MSRs.

Scott Stember - Sidoti

Got it. Okay. And as far as gross margin assumptions, you talked about the OpEx and the tax rate can you maybe just talk about what you expect there particularly when you factor in the Deep River acquisition?

Jeff Buchanan

Yes. We typically don’t give a gross margin guidance, but what we do, do is we have said in our investor presentation and it will be in the one that we give tomorrow that we expect the range of our gross margin to be 37% to 41%. And we have said in the past that we give that range because certain quarters, the gross margin is less like in other quarters, like the current first quarter, because like promotions from shows, like free goods, less volume tend to fall into our Q1/Q2 and then higher gross margins towards the end of our fiscal year. And that hasn’t happened, it didn’t happen last year, because we kept operationally outperforming ourselves during the surge, but this year we think that, that’s a good range kind of depending on the volume in a quarter.

Scott Stember - Sidoti

Okay. And just last just to summarize on the guidance obviously the first quarter looks like it’s going to take the biggest hit because of the seasonal slowdown and MSRs, but is it fair to assume that we should have inventories more closer to optimal levels by the middle part of the year or let’s say the third quarter on the MSRs?

James Debney

Yes. I mean, I expect that we will see strengthening in our MSR business in Q3, probably late Q3 and into Q4 once the inventory of those other brands really works its way through. Obviously, that’s hampering distributors’ ability to perhaps buy the products that they really want to buy. And we are the market leader here and we have some of the most highly desired products when it comes to modern sporting rifles with our M&P 15 range.

Scott Stember - Sidoti

Got it.

Jeff Buchanan

Hey and I just wanted to add in terms of the loading during the year, historically if you go back to 2010, you will see that quarter one and two and three like tend to be, like sort of in the same range for a variety of different reasons. On quarter one and two, it’s manufacturing. Quarter three it’s the holiday we closed down over Christmas yet offset by higher consumer sales. And then the fourth quarter is always higher and substantially higher because of the buying patterns of the distributors. And we expect that to occur the same way this year with the quarter one and two being in the same range. Quarter three maybe a bit higher, because we are trying to build inventory as James said. And we are put in a lot of capacity and flexibility, so that we could try to catch up and get into a situation where when we close down, there is – or have less production days, it doesn’t impact us because – and therefore in a quarter like the third quarter, where you have holiday bind, we are able to supply that.

Scott Stember - Sidoti

Got it. Thanks a lot.

James Debney

Thanks, Scott.

Operator

Your next question comes from the line of Reed Anderson with Northland Securities. Please proceed.

Reed Anderson - Northland Securities

Good afternoon. Thanks for taking my questions.

James Debney

Hi Reed.

Reed Anderson - Northland Securities

Hi. Hey, before I jump in, I have got few questions, but before that, I do have follow-up, Jeff on that gross margin question from the prior caller. So, you said 37% to 41% is kind of a range. And so I mean and again you are not giving guidance, but you do the math and obviously that implies lower gross margins for fiscal ‘15 and ‘14? And so I am presuming a lot of that is just lower sales volumes, but even knowing that it feels like there is – there might be some – is there another element, I guess is are you perhaps baking in a little more promotional activity or pricing or something like that. I am just trying to get a little more granularity on why it is down this year or why it might be down?

Jeff Buchanan

Yes. No, I think it’s those two things that you mentioned. And also on product mix, because really during surge period, you could make or you can sell the higher gross margin products, because distributors and consumers are buying anything that you have to offer. So, we have spent a lot of dollars as we have talked about in the past making the factory flexible, not only building a capacity, but making the factory flexible, so that if the surge occurs or the buying patterns change, we are able to quickly react and say okay, well, if the consumers want anything, then we will make modern sporting rifle that is higher priced than one that is or a higher margin than one that is lower margin. And also I point out that going – even with all the capacity additions that we have done, because we are taking share in handguns, our capacity in handguns is still at around 95%. So, the reduction in the margins is not coming as a result of utilization as much as it’s coming from the things that we just talked about.

Reed Anderson - Northland Securities

That’s very helpful. That really makes a lot of sense. Thank you. So, James then getting back to kind of the outlook and kind of expectations, if you think about handgun piece, which is obviously quarter of your story etcetera and it’s still doing very well. Do you envision that your handgun business overall this year will be up over fiscal ‘14 or is it too early to tell, because obviously a lot of the reduction we are seeing in the revenue I presume was just on the MSR side?

James Debney

Yes. I mean, definitely most of the revenue reduction is coming from MSRs down significantly in the first quarter. So and as I said, it’s going to take some time for MSRs to recover, but yes, handguns remains strong and that’s why we are focused on leveraging our strength in handguns where we believe we have been taking market share and along the way obviously doing all of the smart things to drive profitability. So, we think this will allow us to deliver a very good performance in the softer market. Very likely, yes, we will be flat or slightly up probably with prior year when it comes to handguns, but what you can’t forget is that we have got some meaningful new products coming along in the next 60 days, which are certainly going to help us. And we are very confident that those will be extremely well received by the consumer, but as ever, it’s always a little bit of a wait and see.

Reed Anderson - Northland Securities

Okay. And then just when we are kind of on the demand side, because you are obviously very close to it is when we think about what is selling or the consumer mindset is really you definitely just believe we are in a transition here and that it’s not an issue of as you came with a lower pricing model or chain or lower priced items that kind of thing that, that would help stimulate things. It’s more just balancing what the existing demand is and maintaining pricing integrity. Is that fair?

James Debney

Yes, absolutely. We are not going to be out there reducing our pricing. So we can reduce price at retail. I mean, for us, our product portfolio is very strong. As you know, it’s very broad. It’s also very deep if you think about price. So, as you think about price hierarchies where we are in with the FDVE at a very attractive opening price point for the consumer. And we sell very high end 1911s and revolvers and you know all the products between those two.

Reed Anderson - Northland Securities

Okay, good. Jeff, in the guidance, did you attribute was there accretion from the acquisition included in that? I mean, I think in the past you talked about $0.04, $0.05 and is that baked in or it does not end up being that, I am just getting want to get a sense of where that comes out relative to initial expectations?

Jeff Buchanan

Yes, it’s baked in and it’s – we were holding by our $0.04 to $0.05 estimate of accretion and it’s thus far we have had them we have owned them for six weeks. And the integration thus far has been very good. We are able to have lot of access like to them. Obviously, they are a major supplier. So, we knew a lot about them and we are able to sort of hit the ground running when we bought all the assets. So, I have done a bunch of acquisitions before and this one from an integration standpoint is thus far is pretty early, but it’s been very good.

Reed Anderson - Northland Securities

Good. Alright, I will stop there and we will see you folks tomorrow. Thanks very much.

James Debney

Thanks Reed.

Operator

Your next question comes from the line of Brian Ruttenbur with CRT Capital. Please proceed.

Brian Ruttenbur - CRT Capital

Yes, thank you very much. Couple of follow-up questions. First of all on what have you nobody has really hit on this – hit around this point, but what have you assumed for mix growth in your guidance. So you talked about your guidance and you referred to mix data kind of rebounding in August and on, what have you assumed mix will rebound over the next 12 months within your guidance?

James Debney

Yes, that’s something we don’t disclose. I mean, obviously it’s part of our modeling process to think about mix, because as we all know it’s the best proxy we have for our consumer sales. But really we don’t disclose it, but I gave some color.

Brian Ruttenbur - CRT Capital

Okay. And then on the ERP conversion, how much have you spent to-date is the first quarter? And then how much do you plan to spend in total left, what is left and then highlight where you guys spend in fiscal ‘15 again. I just want to make sure I get the facts right?

Jeff Buchanan

Alright, okay. So we spent a little over $30 million thus far, half of which was capital and half of which was expense.

Brian Ruttenbur - CRT Capital

Got it.

Jeff Buchanan

Alright. We’ll probably spend approximately $15 million for the whole year. A lot of that expense was backend loaded, because we’re on about the same rate, we might not spend as much because it all depends – it’s hard to answer that precisely because it depends when we start additional modules, because those modules are capitalized. And therefore expense that you have, OpEx it disappears, because it goes into capital. Right now what we’re doing and what we expect to be doing for the next 6 months – like 10 months is mainly things that are expensed. It’s still working with the existing program.

Brian Ruttenbur - CRT Capital

Okay. And then at the end of 2015, the majority of the expense is done, you will have spent in total roughly $45 million and everything is 90% done at that point?

Jeff Buchanan

Yes. I mean, once we do these next modules, we’ll probably have end up spending $50 million in total by the time we’re all done over two year or three year period of time, or two and a half year maybe.

Brian Ruttenbur - CRT Capital

Okay. And just one other fact Jeff, the MSRs have the highest gross margins of all your product lines. Is that correct and handguns are number two, number three, how does it rank order?

Jeff Buchanan

No. Actually, we’ve never broken down our products in that detail. I can tell you though and we’ve said this before within a line like modern sporting rifles, you have a range of gross margins. It just depends on the product and features and what the consumers are willing to pay for those products and features. We have said in the 10-K that polymer pistols, in general, are most profitable item from a gross margin standpoint.

Brian Ruttenbur - CRT Capital

Okay, thank you very much.

Jeff Buchanan

Thanks.

James Debney

Thanks, Brian.

Operator

Our next question is a follow-up from Cai Von Rumohr with Cowen & Company. Please proceed.

Cai Von Rumohr - Cowen & Company

Thanks so much. So I’m a little confused still about the SAP. As we read the 10-K, it says that you had $7.2 million in OpEx spend and you are saying $15 million. The third quarter Q suggests that you did about $6 million. So if it’s $15 million, it would have been like $8 million in the final quarter which would have meant G&A would have been down substantially, would have been, I don’t know, like $7 million, $8 million. So I just want to make sure, was it all the $15 million in op expense or was some of that in the gross margin line?

Jeff Buchanan

The $7 million in G&A was just consulting. There was expenses throughout the other $8 million that you are looking for, is throughout the P&L, sales and marketing, cost of goods. I mean, so when you hire the outside guys to come in that goes into one line. But all of the other work, the ongoing work and the stuff that was capitalized and then rolls out of being capitalized is throughout the P&L.

Cai Von Rumohr - Cowen & Company

Got it. But so, how much was in op expense? Was that just $7.2 million? And how much of that will be in the op expense line in fiscal 2015?

Jeff Buchanan

It is the $7 million. And I think depending on how things like roll it could be roughly the same in OpEx in – or a little bit higher maybe in 2015. Some could be in cost of goods sold and elsewhere on the P&L.

Cai Von Rumohr - Cowen & Company

Okay. But so, if we have like $5 million or $6 extra million there in COGS, which we really did not have in the second and third quarter, that’s pretty big number. That would have said, on an adjusted basis, your gross margin in the fourth quarter wouldn’t have been $49 million, probably would have been more or like $44 million, $45 million. Is that a fair statement that would be a more normal seasonal pattern?

Jeff Buchanan

Well, I am not going to – we didn’t get into like detail on the gross margin line. But the $7 million or $8 million was spread over sales and marketing, R&D in addition to cost of goods sold. And it was spread – it was starting from August. So it was three quarters of a year, not just half a year.

Cai Von Rumohr - Cowen & Company

Got it. Okay, thank you very much.

James Debney

Thanks, Cai.

Operator

Our next question comes from the line of Scott Hamann with KeyBanc Capital Markets. Please proceed.

Scott Hamann - KeyBanc Capital Markets

Thank you very much. Good afternoon. I have a couple of questions around the market share change, just in terms of how you get some of the consumer sell-through information. Is the distributors or the retailers giving you POS versus the competition or is it more of survey work you’re doing or anecdotal feedback from the channel? Just how you’re ascertaining share gains for Smith & Wesson brand.

James Debney

Yes, sure. I mean it’s something we’ve explained before in terms of the share analytics that we do and we do it on a monthly basis. So we actually have a sample of independent retailers that we get POS data from on a monthly basis and then simply we have third party, who does all the calculation, share analytics for us and so on, compares it to NICS and gives us a full report on a monthly basis. So that’s how we understand. We also have one distributor – so we’ve been doing that for a number of years. We also have one distributor that recently started to supply us similar data, different sample again of independent retailers. So we actually use that data for inside, so we also use it to validate what we are seeing as well in our own process, for accuracy of results.

Scott Hamann - KeyBanc Capital Markets

Okay. And then in terms of more recently, with the channel inventory, building a little bit for your products specifically, was there increased promotional activity amongst the other players that might have caused your retail momentum to slow down or your share gains to not be as strong kind of post the quarter, something special there or not?

James Debney

Generally, this period, because it is much slow. You will see more promotional activity than in other periods of the year, for sure. Different manufacturers run different sales associate incentive programs and so on. We’ve been running them for a while, a couple of consumer promotions, one of them the M&P15-22, where we’re giving away 300 rounds of 22 ammo with each purchase by the consumer. Those are fairly typical, we’ll probably say a few more of those, as we go through the summer. We also for example did a $75 consumer rebate on our Venture bolt-action rifle. Again that’s fairly typical and we’ll probably see that activity from other players as well. But generally, it’s first summer slowdown in our post surge. Inventory has been largely replenished, so you’re just going to experience this. And as I said, it’s mostly in MSRs when it comes to us. The channel of all brands is, let’s say, very healthy when it comes to inventory, and it’s just got to work its way through, exactly what happened post the surge that ended in 2009. MSRs are the most volatile as we know when you go through a surge and therefore they tend to be the slowest when you come out of that surge period as well once inventory is being replenished.

Scott Hamann - KeyBanc Capital Markets

Okay. And then do you get the sense from your intel on the channel that the competitors have lost a lot of more inventory or an equal amount of inventory versus where you are in the channel?

James Debney

Tough to tell. What I will say is – if we just – are we just talking about MSRs or across everything, Scott?

Scott Hamann - KeyBanc Capital Markets

I guess across everything.

James Debney

Okay. I would say – let’s talk about in broad terms and long guns I would say that as we are the number one in terms of market share probably in units we are one of the highest, but you would expect that because our velocity is higher. So that means low in terms of weeks cover obviously. So, I would say that there is a lot of other brands out there in MSRs who are probably moving incredibly slowly at the moment. Those are the lesser known brands. They have very low aided awareness, okay, compared to Smith & Wesson with the M&P15. So, those will definitely be choking some of those dollars, the available dollars to buy the distributors have and they will be looking to move those as quickly as possible so they can buy the right product. Okay. To talk about handguns, I would still say in terms of inventory, we are probably one of the lowest out there, one of the lowest particularly when it comes to our hotter products such as the Shield, bodyguards, small frame revolvers, all the products that really meet the needs of the consumer when it comes to personal protection.

Scott Hamann - KeyBanc Capital Markets

Okay, that’s fair. And then just final question on the backlog, I know we have talked for years about the backlog in that being meaningful in the way that you do your business, but I mean looking at the year end backlog is down pretty dramatically? And I am just curious if – I mean if that changes the way you know in this environment with not probably being artificially inflated anymore of how you are managing business given that it’s not even representative of a year of or even half a year, I guess of sales at this point?

James Debney

This is the first year that we have really gone out of our way to work with all of our customers to increase the quality of that backlog. So, and with some customers we have actually had them cancel all their orders and reorder so that we know that we have high quality backlog and there is no artificial orders just sitting out as they are never going to be satisfied. So, that’s one of the reasons that you see backlog a lot lower than prior year. It’s probably not one of the main reasons. We are not like some of our competitors who don’t allow customers to cancel orders, postpone orders. We are not rigid like that. We are a customer centric company at the end of the day. And our job is to serve them to the best of our ability. So, holding them to an order that they don’t want is not value add in that partnership.

Scott Hamann - KeyBanc Capital Markets

Okay. So, it’s safe to say going forward that you will be shipping more – continue to ship in line with what your retail sell-through is now that the channel inventories are full and that should sell through should kind of spark your selling?

James Debney

That’s what we want. It’s all about consumer pull. Consumer is the most powerful force out there.

Scott Hamann - KeyBanc Capital Markets

Great. Thanks James.

James Debney

Thank you.

Operator

That concludes today’s Q&A. I will now turn the conference over to management.

James Debney - President and Chief Executive Officer

Thank you, operator. I want to again thank the entire Smith & Wesson team for maintaining their focus on delivering great results. Before we close, I would like to mention that we will be hosting an Analyst Day tomorrow in Springfield. Those of you interested in listening to our prepared remarks during the presentation can do so by our website beginning at 12:30 PM Eastern Time tomorrow. Thank you again everyone for joining us. And we look forward to speaking with you next quarter. Thanks again operator.

Operator

Ladies and gentlemen that concludes today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

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