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Summary

  • Smith & Wesson reported disappointing earnings.
  • Inventories are high as demand has subsided.
  • Management lowered FY guidance, but was transparent in providing expected revenue, earnings, and tax information.

Background

On August 26, 2014, Smith & Wesson Holding Corporation (NASDAQ: SWHC) reported FY 1Q 2015 net income of $14.6 million ($0.26 per share) on sales of $131.9 million compared to net income of $26.5 million ($0.40 per share) on sales of $92.7 million in FY 1Q 2014. These results came in below Estimize-reported consensus earnings estimates of $0.28 per share on sales of $137.81.

Smith & Wesson Holding Corporation manufactures and sells firearms in the United States and internationally. It's products include revolvers and pistols, bolt-action and single shot rifles, and semi-automatic rifles. Its main brands are Smith & Wesson, M&P, Thompson/Center Arms, and Performance Center. It was founded in 1852 and is based in Springfield, Massachusetts.

Its main publicly traded competitor is Sturm Ruger & Co., Inc. (NYSE: RGR)

Key Points

  • Industry-wide inventory builds and summer slowness have yielded unfavorable channel conditions
  • Long guns, including AR-15 type models (referred to as Modern Sporting Rifles) drove 87% of the company's 1Q decline in sales
  • 18.5% operating margin vs. 28.1% in the prior year
  • Operating expenses of $23.3 million (17.7% of revenue) vs. $24.8 million (14.5% of revenue) in the prior year
  • Gross margin of 37.2% vs. 42.6% in the prior year
  • Long gun revenue decreased 67.2% from the prior year
  • Handgun revenue decreased 3.2%
  • $83.3 million in cash
  • $75 million line of credit
  • Operating cash flow of $10.8 million
  • Lowering guidance

Guidance

  • Total capital spending in FY 2015 will be about $35 million
  • Revenue to be between $100 million and $110 million for 2Q FY 2015
  • EPS $0.04 and $0.08 for 2Q
  • For the year, revenue to be between $530 million and $540 million
  • EPS for the year to be between $0.89 and $0.94
  • Cash balance expected to be "in excess" of $125 million
  • Effective tax rate of $37% for the rest of the fiscal year
  • Operating expenses of $25 million through the rest of the year
  • No additional stock buyback or dividend until after the end of the fiscal year
  • "Almost done" with its most recent $30 million buyback authorization
  • Anticipate "37% to 41%" gross margins

What to look for in Q2

Legislative environment

The firearms industry is highly regulated, and as such, is subject to an ever-changing legal environment. As such, there is always the potential for additional gun control measures to be introduced and passed, which would adversely affect S&W's business.

Government contracts

The U.S. Army is searching for a new handgun system, and management stated that it is ready to submit its M&P polymer pistol when proposals are requested. While the company stated that the selection process will take "several years" it is always something to watch for.

Quick Take

It's clear the company built up too much inventory that it has been unable to sell. The firearms market is highly cyclical, and sales of S&W's high margin handguns and semi-automatic rifles are subject to strong political scrutiny and are constantly threatened by pending legislation. While the current political environment has not resulted in substantial federal gun control measures, it has encouraged a buying spree among firearms enthusiasts over the past several years. Smith & Wesson reacted to this demand by operating facilities at full capacity, which resulted in them having a surplus inventory.

Management continuously cited that the industry as a whole produced a surplus and reiterated that they believe that demand will normalize. Management did not explicitly say that they lost market share, but the fact that there is more product from competitors in retailer inventory shows that offloading their inventory will be extremely difficult without discounting or a an influx of demand.

Management partially addressed their inventory issue when questioned about production and stated that in order to reduce inventory, they will cut back production and keep inventory at around $75 to $80 million.

I really like how they presented numbers when asked, such as anticipated gross margins and inventory levels. Additionally, it was great that they provided earnings and sales guidance for both the quarter and the rest of the year. However, I was a little confused when they kept referring to the company as "the market leader" in firearms - it's certainly not in sales, as they sell far fewer firearms than many of their competitors, and they did not really quantify what that meant. They referred to a third-party report that they did, but did not give a concrete answer.

Management gave pretty good answers when questioned, and were transparent with respect to guidance and the challenges that the company faces. I would have liked to have a bit more color about how the company plans on reducing its inventory, as management made it clear that is the main issue the company is facing.

Conference Call transcript is available on Seeking Alpha here, 8-K with financial data is available from the SEC here.